Howard Lin of Cielway: How to Manage Mortgage Servicing Rights in This Fast Market
Howard Lin is president of mortgage risk analytics company Cielway, New York. He has more than 10 years of experience in the financial services industry, with a recent focus on mortgage servicing and capital markets. His experience ranges from portfolio valuation, predictive analytics, trading and technology innovation for several Wall Street investment banks. He also consulted FINRA on market surveillance in the regulatory regime. He received a Ph.D. in Engineering from Cornell University.
While the mortgage origination market has been experiencing strong headwind as the industry embraces for rising interest rates that leads to lower refi and rising cost to thinning margin, on the other side of the industry mortgage servicing rights market has been roaring since the start of the year.
Naturally you will think how you can ride the wave of this incoming tide. And indeed, mortgage servicing rights are a natural hedge to those who primarily focus on the origination side of the business. However, retaining servicing rights is not an easy business, not to mention properly valuing them, especially when the current volatile interest rate movement makes hedging a task only to the most sophisticated mind.
Unlike origination business, which is short-term transaction based with revenue coming from lead generation and conversion, servicing is mostly based on servicing fees earned on longer term relationship with existing homeowners. The longer you can hold on to these customers, the more revenue you can generate from these loans. Therefore, the MSR value of your portfolio is based on a multiple of annual servicing fees you can earn. It is usually between 2 and 6 for the past decades.
On a very high level, this multiple can be understood from a perspective of how long these loans can stay on the book. In reality, life can be more complicated. The income from your portfolio is more than just the servicing fee. You can accrue interest on customers’ P&I, T&I payments, so-called floats, which contribute 30% of servicing rights value, along with a few other income and expense components, of which we won’t go into details here. All these cash flows will be discounted back to the present to get the proper valuation of MSR.
The key to estimate how long these loans can stay on your book is to understand both the run-off and credit risks of your portfolio. The rising interest rates initiated by the recent Fed monetary policy to contain inflation has significantly cooled down the refi mania seen in the past two years. On the other hand, the same cooldown of refi has significantly driven up the valuation of MSRs, due to a slowdown of prepayment speed of the borrower and hence longer retention time on servicing portfolio. That is why servicing is a natural hedge to the origination business. Also, the large appreciation of home price in this red hot market creates a higher equity buffer to the downside risk of a credit event hence additional boost to the MSR valuation. The recent MSR transaction has shown the pricing reaching north of 5x for GSEs MSR offerings and 4x for Ginnie Mae from the low 2x two years ago.
In general, MSR valuation is difficult, because these assets are hard to value. They tend not to be homogenous, as they differ by loan size, note rates, servicing fees, maturity, credit quality and the entity that provides a credit guarantee on the underlying loan, among other characteristics. And as a result, you will normally see a lower valuation for Ginnie Mae offerings than GSEs, due to higher delinquency and higher cost to service.
Financially speaking, MSR functions as an interest rate only products in that the servicing fee is deemed as an interest on the unpaid principal balance. Each loan is valued based on the discounted future cash flow. The two prominent factors determining the future cash flow are borrower prepayment and credit performance generalized as loan performance. Prepayment shorten the lives of the loan and default means not only a reduction of cash flow but also a higher cost of servicing especially on the compliance part.
Loan performance and cash flow generation have been traditionally rendered on a pool or “rep line” level in the past, due to limited available dataset and computation power. It puts loans of similar characteristics together for performance measurement. Hence, large portfolio containing more than hundreds of thousands of loans can be reduced down to a few hundred or less rep lines to calculate.
The constraint on computational resources becomes much more severe when sophisticated industry practitioners use option-adjusted model (OAS) for valuation that employs more than hundreds of possible future interest rate paths and look at the averaging effect on price. This model proves to be very useful in that many of the interest rates products to hedge MSRs, such as interest rate swaps, futures and TBA are also priced with such model. But it entails an equivalent of hundreds of more calculations than the simple static model using just one single future interest rate assumption. Static model suffers from more volatile pricing and hedged return.
The valuation methodology based on rep lines will not capture many nuances of loan level detail needed for better loan performance projection. Recently loan level analytics has become available thanks to the cloud computing technology. Capacity can easily reach hundreds of millions of loans with results coming back in minutes. With such powerful technology at your side, secondary marketing people can overcome the challenges of valuing these hard-to-value assets with more tunable variables, more granular details and more advanced model to achieve a more stable and consistent portfolio valuations. And finally, they can price more frequently as needed during the volatile market movements seen this year.
The recency, frequency and monetary values factors as prescribed by the RFM model will make MSR valuation and hedging more tractable for practitioners.
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