Where The Money Comes From

Pros, cons of the three ways mortgage companies get paid

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Victoria DeLuce

In my last article we discussed what affects the bond price and gave a crash course in hedging. To continue our journey on becoming the interest rate expert, we are going to focus on servicing values and servicing rights.

Again, the five main variable components that go into rate-sheet pricing and interest rates are the bond price, servicing value, lenders’ cost to manufacture, loan originator compensation, and the borrowers’ risk profile.

Each mortgage loan has two components of value: The interest rate attached to the actual loan and the value to service that loan.

All mortgage companies lend, unless they are going out of business, but not all mortgage companies service loans.

Servicing loans is a completely different business than lending. There are companies whose sole purpose is to service the loan. Servicing companies or servicing divisions handle all payments after the mortgage loan closes. They collect the mortgage payment from the borrower and pay all interested parties. They pay the bondholders, the homeowners’ insurance company, municipalities for taxes, etc. Mortgage servicers also handle all borrower communication and loss mitigation in the event of default.

This is a lot of work, and those companies want to be compensated for it. The longer a mortgage is going to be around, the higher the servicing value will be and vice versa. The length of time a mortgage will be around is primarily tied to the interest rate on the loan and what markets and traders expect to happen in the economy in the short- and long-term future.

The next time you see fluctuations in a rate sheet that don’t track exactly to the market or change in bond price, changes in servicing value is often the culprit.

There are three ways mortgage companies are paid for the servicing value. They either service the loan themselves and are paid over time as the borrowers make their payments. They service the loan for a while, then sell a pool of servicing to a third party. We refer to this as MSR value: the value of mortgage servicing rights. Or they sell the servicing up front right after the loan closes and the mortgage company is paid a SRP or servicing release premium.

There are pros and cons to all three scenarios, but one of the main reasons mortgage companies sell servicing up front in the form of an SRP is to receive money today vs. receiving incremental payments over the life of the loan. If a mortgage company does enough volume, it could make sense to service mortgage loans as it becomes an additional cash flow and servicing is typically a natural hedge against interest rate changes. There also is the benefit of retaining the client as a lifelong consumer for future refinances.

The next time you see fluctuations in a rate sheet that don’t track exactly to the market or change in bond price, changes in servicing value is often the culprit.