Why We Care About Mortgage Servicing

Prepayment speeds are the key driver behind servicing values

Insider

Contributing Writer

In the past, handling a borrower’s monthly payment was relatively straightforward. The servicer, more often than not the lender, would receive the check or bank transfer around the first of the month, hopefully by the 15th, deposit it in the correct account, and then possibly remit most of the payment to the investor. Servicing, and its ramifications and complications, has evolved, however, and as we enter the summer months of 2023, servicing is worth revisiting.

A mortgage servicing right (MSR) is the strip of interest from the loan. Based on the accounting rules, it becomes an asset when a mortgage loan is sold and servicing retained. Mortgage servicers are responsible for collecting payments on the mortgage loan and distributing these payments to appropriate authorities (including investors, tax authorities, and insurance companies). The Consumer Finance Protection Bureau (CFPB) has taken an increased interest in ensuring all of this is done correctly, and that when servicing is bought or sold, the corporations handle it well, and that there is no confusion on the borrower’s part.

Speaking of which, the pace of blocks of servicing, large and small, being sold and bought has increased dramatically and should continue to the end of 2023, if not beyond. MIAC, Phoenix, Incenter, RAMS Mortgage Capital, Mountainview, to name a few companies, are actively involved in servicing transactions. “Why?” Smaller companies, which added servicing during the pandemic because aggregators weren’t paying for it, now need the cash to try to outlast their competitors with margins and volumes having declined.

Few Hedges

For those companies who opt to retain their servicing, given that the value of the mortgage servicing rights represents the lion’s share of the value of a lender and servicer, protecting the value of the servicing is very important. Like commodity prices, or a locked mortgage pipeline, the value of MSRs can be hedged but very few smaller companies do that.

Servicing is a numbers game. Simply put, if it costs a servicer $10 a month to service a loan and is paid $50 a month to do so, it is a source of revenue. The longer that situation exists, and the loan is “on the books,” the better. Originating or buying servicing and valuing it as if you’ll own it for years, only to have it pay off (prepaying) in four months, is a money-losing situation. The value of servicing is the net present value of the servicing revenue components less expenses, adjusted for prepayment speeds. So, if expenses increase, or the income decreases, it is a problem. The servicer also can earn income from late fees, ancillary income, and float income.

Put another way, on the income side MSR valuation is composed of service fee revenue, escrow float earnings, principal and interest (P&I), and payoff float earnings, ancillary income (e.g., late fees, modification income, optional insurance, etc.). On the expense side, there are servicing costs, additional costs for delinquent loans and foreclosures, advances on delinquent P&I and escrow payments, interest owed on escrow accounts in some states, interest owed on early payoffs (unique to scheduled / scheduled products), prepayments, voluntary payoffs through refinances, and involuntary payoffs through foreclosures.

Earning More Revenue

The value of the servicing “book,” if held, is usually the primary source of value on the balance sheet. And prepayment speeds are the key driver behind servicing values: The longer a performing MSR is held in the portfolio, the more revenue will be received. And as interest rates rise, prepayment speeds will slow down. That increases the duration and resulting value of the MSR. And as interest rates drop, prepayment speeds will rise, which will decrease the life and the value of the MSR. As rates rise, voluntary speeds slow and the cash flows extend, increasing values, and as rates fall, voluntary speeds increase and the cash flows shorten, decreasing values.

Brokers see the results of all these calculations and forecasts in their daily mortgage pricing. They can read the borrower’s complaints in the CFPB’s published information and hear the occasional confusion from borrowers whose mailing address has changed for their monthly payments. They also see how some large companies with large amounts of MSRs place a value on the servicing that may be below or above the accepted market value.

However, the basic premise of servicing remains the same throughout all of this. A loan is given to a borrower who agrees to make their payments in a timely fashion. When the borrower does that, in the vast majority of cases, the “system” works. When the system doesn’t work, for whatever reason, brokers and LOs can step in to answer questions, once again adding value and further solidifying their relationship with the borrower.