The Rush to Buy Receivables

The home mortgage receivables market is on fire. Spurred by the twin forces of rising interest rates and industry consolidation, residential loan servicing portfolios are selling like crazy, and at prices close to their all-time highs.But there could be trouble for the mortgage banking firms who are anteing up for big servicing portfolios, if interest rates drop suddenly and borrowers start to refinance again. At this point in the cycle, however, that doesn't seem likely any time soon.In February and March, roughly $55 billion in servicing rights changed hands as mortgage banking firms-both bank-owned franchises and otherwise-bid up the value of this sometimes cagey asset. And that figure doesn't include $80 billion in mortgage servicing rights that could transfer when General Electric finally unloads its Cherry Hill, NJ-based G.E. Capital Mortgage Services subsiding.To put the $55 billion number in perspective, consider this: Just 13 firms in the U.S. actually service more than $55 billion in residential loans. (The largest is Chase Manhattan Mortgage with $310 billion.)Greg Bennett, president of Hamilton Carter Smith, an investment banking firm in Beverly Hills that sells both mortgage franchises and loan portfolios, says his firm brokered seven servicing deals in the first three months of 2000, compared with 11 for all of last year. (A list of recent receivables sales appears on page 57.)Indeed, the servicing market is so hot right now that broker/advisors who sell servicing for a living say the prices being paid for receivables are flirting with all-time highs. "Prices are stellar right now," says Steven Tannehill, chief operating officer of Countrywide Servicing Exchange, based in Calabasas, CA. "Right now interest in bulk servicing is really strong." "Bulk" servicing is industry jargon for servicing rights that already sit on the books of a mortgage banking company. Keep in mind that, on average, servicers of conventional one-to-four-family loans receive 25 basis points of the note rate for processing monthly housing payments from consumers. In short, servicing represents a cash-flow stream. When a firm like Chase buys bulk or existing servicing, it is purchasing the cash flow on mortgages that have already been originated. In contrast, when Chase buys "flow" servicing, it is buying the cash-flow stream on loans that are expected to be originated over a given period of time.One of the great ironies of the residential mortgage banking market is that as originations decline, as they have during the past three quarters, the value of servicing rights increases. This occurs because as interest rates spike-which causes loan volumes to drop, since borrowers stop refinancing-servicing is more likely to stick around for a long time. The longer servicing sticks around, the greater the total revenue stream produced from that servicing. But the mortgage industry has seen these cycles before. What makes the current bull market in servicing so notable? In a word: consolidation. Over the past five years, fewer and fewer mortgage firms service the nation's outstanding residential receivables. At last count there were about $4.9 billion in housing receivables or "servicing rights."The consolidation trend has raised the stakes for mega-servicers such as Chase, Norwest/Wells Fargo Mortgage, Bank America Mortgage and Countrywide Home Loans Mortgage, each of which service $250 billion or more in home loans. (In case you are benchmarking, the No. 20-ranked servicer, World Savings and Loan of Oakland, CA, services $42 billion.) The receivables portfolios of these firms have grown so large that they need more and more product to justify their existence. That's partly because big servicers need to buy a lot just to replace natural run-off from maturing portfolios. Also, the cost of running a large operation dictates that they keep growing.How best to do this? By acquiring servicing on the open market. The more desperate buyers there are out there, the higher the prices.Tannehill of Countrywide Servicing Exchange points out that most of the mega-servicers that bid on servicing rights in the open market traditionally won't even bid unless the available package of receivables is $1 billion or more. But competition has been so stiff lately that many are lowering the bar, bidding on portfolios of $500 million or greater. Notes another servicing broker, "Normally they couldn't be bothered with these types of deals."The price paid for servicing is typically measured in terms of a multiple of the servicing fee. Built into the note rate, the standard servicing fee on Fannie Mae/Freddie Mac-conforming loans, is 25 basis points. The fee on government-backed loans is 44 basis points.Countrywide Servicing Exchange estimates that a $1 billion package of Fannie Mae loan servicing, where the average loan yield is 7.4% or so, will sell for 6.25 times the servicing fee, or 156 basis points.Ted Jadlos, a principal in Phoenix Capital, a servicing advisory firm based in Denver, says that he has seen bulk servicing portfolios in which the average note rate is between 7.25% and 7.5% sell for as much as 7.5 times the servicing fee.Tom Donatacci, managing director of Cohane Rafferty Securities Inc. of Harrison, NY, cautions that prices are so high right now that they "are almost capped out…servicing is worth about as much as it could be worth." One risk for firms paying these high multiples is that, if interest rates drop suddenly, the servicing they are buying at today's premium prices could disappear as refinancings pick up again. In other words, buyers of premium product could be setting themselves up for future writedowns.But so be it. For now, few buyers (and their advisors) seem concerned. Interest rates fell slightly in March but are still in the range of 8%, with half-a-point or no points-hardly conducive to a refi boom or even a boomlet.With loan production anemic compared to record years in 1998 and 1999, servicing is the only game in town for mortgage bankers. Servicing means cash flow, and in the world of mortgage banking cash flow is king.