Even though they stand at the heart of the mortgage turmoil, servicers by and large have been spared from the wreckage that has befallen originators and investors.
However, there are signs that servicers' relative safety is eroding. Operating costs are rising as these companies do more of the hands-on work of attempting to provide relief to troubled homeowners and (more often) acting as agents in foreclosure proceedings. Also, servicers have to advance principal and interest to investors until problems with a loan are resolved or the loan is liquidated, and such advances have increased.
In recent weeks problems at servicing units contributed to profit warnings by First Horizon National Corp. and Regions Financial Corp. If such hits were to develop into a full-blown trend, it might undermine the conventional wisdom on the inherent hedging that servicing provides originators, and it could cool some of the acquisition interest that servicers have continued to enjoy.
Throughout the credit crisis, buyers have demonstrated a sustained appetite for servicing operations, picking them out of otherwise moldering mortgage companies. And tougher borrowing terms (at least outside the prime sector) have translated into longer lives for contracts to bill certain classes of borrowers — a force that typically makes such contracts more valuable.
But last week Regions announced a list of unusual fourth-quarter charges, including $42 million of "other" pretax "valuation-related expenses, the majority of which relate to its mortgage servicing business."
Last month First Horizon cited "potential adjustments to the carrying values of mortgage servicing … in light of current market conditions" as part of the reason it expects to report a fourth-quarter pretax loss for its mortgage business. A spokesman for the company would not elaborate on its announcement.
But Fred Cannon, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., wrote in a Dec. 21 research note that First Horizon "implied that the value of servicing would likely be down" because of credit issues. "This is an important statement for all mortgage lenders, as the decline in prepayment speeds had been thought to increase the value of servicing," Mr. Cannon wrote. "However, it appears that credit-related servicing costs are overwhelming the impact of slower prepayments."
Anthony Sepci, a partner in KPMG LLP's financial risk management practice, said that given the current credit environment, "with a tremendous spike in delinquencies, the cost of servicing these pools has increased materially."
On average, servicers are paid a fee of about 50 basis points annually for subprime loans in securitizations, Mr. Sepci said. "Traditionally in an adequately performing credit market, like 2004 or 2003 or even 2005," that rate "basically was fair and adequate compensation," but in the current environment, "for a lot of participants … maybe it's not enough."
For instance, "when you modify a loan, and you contact a borrower, basically re-underwrite the loan, and work with them through their issues, you're incurring costs of anywhere from $700 to $1,000 dollars per interaction," he said.
In addition to advancing principal and interest, servicers also typically are required to cover a variety of costs during foreclosure, though eventually they are reimbursed.
"The advances are going up in general, and for nonbanks, financing those advances has become more difficult and more expensive," said Jeffrey M. Levine, a managing partner with Milestone Advisors LLC of Washington.
In portfolio trades, "you're seeing a lot more attention" being paid to advances, "which historically no one ever gave … a second thought," Mr. Levine said.
However, some observers said that rising servicer expenses have been counterbalanced by slower prepayments and late fees, and that much depends on the individual characteristics of the servicing portfolio and the servicer's capacities.
Delinquencies "can be very profitable for the servicer," said Charles N. McQueen, the president of McQueen Financial Advisors, a Royal Oak, Mich., investment advisory firm that performs mortgage servicing valuations. "It should work that way if you're a large enough servicer, due to economies of scale — your fees more than cover your expenses."
Mr. Levine said that it would be "fair to say" that servicing costs are increasing, "but in terms of the overall economic picture, you'd be telling an incomplete story if you felt that was just net negative on the value of servicing."
For example, a slowdown in prepayments and a revenue boost from late fees act as counterweights, he said.
But Mr. Sepci said late fees may not be enough.
"On average, late fees are approximately 10 basis points," he said, but those fees, even when combined with the standard 50-basis-point servicing rate, would not cover what some servicers are asking to take on some very high-delinquency portfolios.
And slowing prepayments also may have negative consequences for servicers.
The slowdown may be "contributing to the higher delinquencies as more accounts have a higher probability of default now, and therefore higher cost," said John Panion, a senior manager in KPMG's financial risk management practice.
"In the past some of those accounts would have just paid off."
Sachit Kumar, a managing director with Mortgage Industry Advisory Corp. of New York, said that to the extent that balance-sheet valuations of mortgage servicing rights are tied to market trades of portfolios, demand for servicing assets may be propping them up.
"When production is down, people want to maximize the servicing platform" and look to acquire portfolios to keep servicing operations busy, Mr. Kumar said.
Mr. Levine agreed that there has been increasing interest in servicing portfolios.
"When production slows down, the large aggregators that need to replace their own servicing portfolio are looking to replenish it with bulk acquisitions of servicing," he said.
The portfolio of the largest servicer, Countrywide Financial Corp., grew 17.3% to $1.5 trillion at Sept. 30 from a year earlier. Over the same time, the Calabasas, Calif., company's "reimbursable servicing advances" grew 71.4% to $2.9 billion.
However, Countrywide said in its third-quarter filing with the Securities and Exchange Commission that the value of its mortgage servicing rights "was positively impacted by an expectation of slower future prepayment speeds."
