Mortgage Servicing Rights: Valuation
Question: We are considering whether to sell our mortgage servicing rights. This has been a long, drawn out process of complicated decision-making. At this point, we are still struggling with how to determine the valuations. Perhaps there is a given set of valuation criteria that we could use. Essentially, we just want to be sure we are including the basics in our valuation. Is there a set of valuation data sets that we should be considering in our valuation approach?
Servicers Compliance Group, our affiliate, handles due diligence for virtually all aspects of mortgage servicing, so this is a subject with which we have considerable familiarity. First, it is important to define “mortgage servicing rights,” often referred to by the acronym “MSR”. At the most rudimentary level, MSRs are the capitalized value of the right to receive future cash flows from the servicing of mortgage loans. The concept of capitalized value asserts that the current value of an asset can be determined based on the total income expected to be realized over its economic life span. Those cash flow periods are the anticipated earnings, as discounted (viz., given a lower value), so they take into account the time value of money.
MSRs are considered a source of value derived from originating or acquiring mortgage loans. Because residential mortgage loans typically contain certain features, such as a prepayment option, borrowers often elect to prepay their mortgage loans by refinancing at lower rates during declining interest rate environments. But, when the refinance occurs, the cash flows generated from servicing the original mortgage loan are terminated. Thus, the market value of MSRs is extremely sensitive to changes in interest rates. For instance, the MSR market value tends to decline as market interest rates decline and increase as interest rates rise.
It is usual to capitalize MSRs on the fair market value of the servicing rights associated with the underlying mortgage loans at the time the loans are sold or securitized. Generally Accepted Accounting Principles (GAAP) requires that the value of MSRs be determined based upon market transactions for comparable servicing assets or, in the absence of representative market trade information, based upon other available market evidence and even modeled market expectations of the present value (PV) of future estimated net cash flows – such as internally developed discounted cash flow models to estimate the fair market value – that market participants would expect from servicing.
Obviously, valuation requires considerable expertise. I offer here a few of the many possible ways to process assumptions in a valuation of MSRs. This outline is by no means comprehensive. It assumes that MSRs are carried at estimated fair market value.
►Prepayment: This is the most significant driver of MSR value based on the actual and anticipated portfolio prepayment behavior. Prepayment speeds, sometimes referred to as “velocity,” represent the rate at which borrowers repay their mortgage loans prior to scheduled maturity. As interest rates rise, prepayment velocity generally slows down, and as interest rates decline, prepayment velocity generally accelerates. When mortgage loans are paid off or expected to be paid earlier than originally estimated, the expected future cash flows associated with servicing such loans are reduced.
►Discount Rate: The cash flows of MSRs discounted at prevailing market rates, which often include an appropriate risk-adjusted spread.
►Base Mortgage Rate (BMR): This is the current market interest rate for newly originated mortgage loans. It is considered a key component in estimating prepayment speeds of a portfolio because the difference between the current BMR and the interest rates on existing loans in the portfolio is an indication of a borrower’s likelihood to refinance.
►Cost to Service: Servicing costs are based on actual expenses directly related to servicing. These servicing costs are compared to market servicing costs when market information is available. It is advisable to include expenses associated with activities related to loans in default.
►Volatility: This is an assumption that represents the expected rate of change of interest rates. The rate of change is often notated with this sign Δ and is referred to as “Delta”. Without getting too technical, the Delta is used in valuation methodologies to place a theoretical boundary around the potential interest rate movements from one period to the next.
As you proceed with your valuation approach, it is important to reconcile actual monthly cash flows to projections, which means reconciling actual monthly cash flows to those projected in the MSR valuation. After each such reconciliation, an assessment should be undertaken to determine the need to modify the individual assumptions used in the valuation.
Jonathan Foxx is managing director of Lenders Compliance Group, the first and only full-service, mortgage risk management firm in the United States, specializing exclusively in outsourced mortgage compliance and offering a suite of services in residential mortgage banking for banks and non-banks. If you would like to contact him, please e-mail [email protected].