How 3 companies gambled on MSRs and won
Aggressive MSR portfolio acquisition strategy puts them in sweet spot
Three companies have significantly invested in servicing portfolios, gobbling up MSRs like marbles in Hungry Hungry Hippos over the course of the past two years.
Ocwen Financial Corp. (OCN), Nationstar Mortgage Holdings (NSM) and Walter Investment Management Corp. (WAC) were leaders in buying servicing rights. All three doubled in size in the last 24 months, and all three firms rank among the top 10 largest U.S. mortgage servicers.
Given this strategy of volume acquisitions, Moody’s Investors Service examined the servicing stability of these three entities and studied their foray into originations, their integration of the acquired servicing portfolios and platforms, their deployment of excess cash flow, and the impact that the improvement in the housing market and economy has had on their performance.
Moody’s looked at how these three leaders have grown dramatically following the financial crisis, and at the rapid transformations that pose significant operational risks that constrain their credit ratings.
"Opportunistic bulk acquisitions of credit-impaired residential mortgage servicing portfolios have largely fueled this growth," Moody’s reports. "These companies are transitioning from performing non-prime servicing to providing full-service mortgage banking. They now originate prime agency-eligible mortgages and service a full spectrum of mortgage loans, from the seriously credit-impaired to super-prime."
"As the housing market continues to improve, the companies will benefit from increasing profitability, a credit positive. Nevertheless, the companies’ high growth rates will challenge their ability to service loans, a credit negative," Moody’s concludes.
Moody’s thinks that the risk was worth it, given the expanded origination capacity the three have now provides a much-needed source of organic growth.
"Over the last year, all of the companies significantly increased their capacity to originate prime agency mortgages, primarily through acquisitions. This new source of revenue growth will at least partially offset the risk that prepayment will reduce the assets in the companies’ servicing portfolios (run-off risk). Origination is the new frontier for the mortgage servicers," Moody’s says.
But, Moody’s warns, "It is uncertain how well the companies will be able to compete with banks in prime mortgage banking over the long term. Nonetheless, origination is an important credit positive addition to the mortgage servicers’ product and revenue mix. However, given the companies’ histories as non-prime originators, their wealth of non-prime servicing experience, along with the cyclical, low-margin nature of prime mortgage originations, they could look to become the next generation of non-prime loan originators – adding risk to their credit profile."
Other findings from Moody’s:
The companies’ growth rates will likely slow significantly as they transition their newly expanded full-service mortgage banking offerings from acquisition-based growth to organic growth. This strategic shift will increase the companies’ free cash flow, particularly as they realize the benefits of significant investments in their servicing businesses.
However, sustained success will depend largely on how the companies choose to deploy this excess cash flow. Sacrificing profitability or increasing operating risks to continue their rapid growth would be credit negative, let alone defending their current servicing market share. The stock prices of all three companies, in particular Nationstar and Ocwen, have risen rapidly in the past two years on expectations of continued success, increasing the pressure on management to continue to deliver high growth and positive results.
- Since the delinquency rates of special servicers’ servicing portfolios are far higher than those of prime servicers, special servicers have the most to gain from the declining delinquency and default rates that accompany a rising housing market. First, their expenses will be lower with a better performing portfolio: the cost of servicing delinquent loans is approximately 10 times greater than the cost of servicing current loans. Second, their fee revenues will increase, since higher interest rates lower prepayment rates, in turn increasing the duration of their servicing portfolios and the valuations of their mortgage servicing rights (MSR). A small change in projected prepayment rates has a big impact on the value of a servicer’s MSRs.