Servicing mortgages has always been a thing of value, for the most part, and a source of income in difficult times. And in difficult times, companies have sold their servicing rights or are continually adjusting their holdings to focus on business goals and objectives. A bank may only want to own servicing in its own branch footprint, for example. What is the market seeing among clients who are selling servicing?
There are really two “flavors” of mortgage servicing rights out there. Current coupon, which would be servicing rights that are based on current originations, near current rates. Current coupon servicing rights have a unique risk profile with a lot of convexity characteristics. If interest rates go up, they have the potential to appreciate in value. And if interest rates go down, they have the potential to depreciate in value.
The unique thing about mortgage servicing rights is that they are not backed by any principal. So, if a mortgage loan pays off, your investment is gone … 100 percent of your investment is gone. As opposed to investing $300,000 in a mortgage loan and the investor collects interest on that loan. But if the loan pays off, the investor receives their $300,000 back. So current coupon servicing rights have a particularly interesting risk return profile — and there are lots of different ways to monetize that value, hedge that value, and capitalize on that investment.
Then there's the low note rate flavor, which is mostly servicing rights on loans that originated in the COVID pandemic era: 2020, 2021, 2022, and maybe a little bit in 2023. Those are characterized by very low rates: 2.5, 3, 3.5 percent. Those homeowners likely aren't going to be refinancing or paying off the mortgage, although some are based on life’s needs or credit card debt.
So consequently, the risk profile for a servicing investor or mortgage servicing rights investor in those kinds of servicing rights is very low. The returns tend to be very low. And similarly, there is very little convexity — meaning if interest rates were to go very, very low, those loans could pay off. But as interest rates continue to go high, there is really no more appreciation value possible in those servicing rights because they can't prepay any more slowly than they're already prepaying today.
As summer winds up and we head into autumn, who is currently buying and who is selling, and why? A lot of the big buyers in the market are companies like Rocket/Cooper, Bayview/Lakeview, Freedom Mortgage, Carrington, and BSI. They're all buying mortgage servicing rights because they see an opportunity to monetize the relationship with borrowers beyond simply the collection of a fee to service their mortgage loan.
Collecting a fee to service a mortgage loan is a relatively uninteresting business. It's a back office intensive bill and receipt kind of a business. In the conventional space, there aren't a lot of delinquencies out there, and so there's not a lot of default servicing required. It's really just a question of who can be the most cost efficient, who can process payments the best, who can have the least expensive banking relationships and lockbox facility.
But what's more interesting is being able to try to monetize those borrower relationships. Mortgage originators spend a lot of money buying leads. They partner with Lending Tree, they partner with lead generation firms, they buy leads, they market aggressively, all with a goal of trying to find new mortgage borrowers. In the case of someone who buys a portfolio of mortgage servicing rights, you have a captive lead. They are now a client. And therefore, if you can monetize that client relationship by offering additional mortgage products over time, there are some in the industry who have suggested that there could be a cross-sell opportunity of three to five additional mortgage loans over the life of a relationship. In today's market, there's a lot of second mortgage lending going on for a lot of folks that have very low note-rate mortgages.
They have a lot of equity that has built up on their property as a result of home prices going up so much since the early 2020s. And so, they don't want to sell their home, or they don't want to refinance their home, but they'd like to get equity or cash out of their home. And the second mortgage market has been growing dramatically over the last three years as people take out second mortgages to take equity out of their homes.
These loan products are profitable for mortgage originators, and a very profitable way to originate these loans is to find leads. And the way to find leads is to buy mortgage servicing rights.
The unique thing about the way that institutions often acquire mortgage servicing rights is through partnerships, and each entity brings a number of critical elements to the table. Who is approved by Fannie, Freddie, and Ginnie to own mortgage servicing rights? Is one company an ongoing servicing operator in many, if not all 50, states? While there are sponsors of excess spread structures, there are very few sponsors who are actually operating platforms as well. And so, as an institutional investor, you are engaging not only with a notable and experienced capital markets partner, but also with an operating platform that's going to service your loans.
The economics of retaining servicing these days is still attractive to many. The servicing fee that one collects as compared to the cost of servicing is usually beneficial. If a company were to buy 25 basis points of servicing on a conventional loan, it is very likely that their cost to service is probably in the neighborhood of three basis points, so consequently that company has 22 basis points of excess spread. This can be a very attractive return on capital. Further, you can leverage that by borrowing against it. You can borrow up to 60 percent, or in some cases 70 percent, of the value of that servicing portfolio. And so that amount of leverage will definitely increase and enhance an investor's return.
The industry is looking for trends that will impact business in the future. As homeowners “face off” against servicers who are ever larger in size, for example, what will happen to customer service? Try to get somebody at Verizon to answer the phone, try to get somebody at AT&T to answer the phone. At some point in time, it could be equally difficult to get someone at a servicer to answer the phone.
