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Why buy MSRs in this regulatory environment?

IMN panel talks about the high cost and profit of MSRs

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So given that four of the four sessions Monday morning at the Information Management Network’s first-ever Residential Mortgage Servicing Rights ended up circling around to the regulatory costs and scrutiny of myriad regulatory bodies such as the New York Department of Financial Services and the Consumer Financial Protection Bureau, one moderator asked a fair question:

Why would anyone want to buy MSRs in this regulatory environment?

(Note: IMN asks for the conference to be off the record. With exceptions, panelists are quoted but not named.)

“It’s hard for mortgage originators to hold MSRs – they are too expensive to service them,” one panelist said. “So servicing is accruing to entities that aren’t traditionally MSR holders.”

Accruing they are. MSRs have grown into a $10 trillion market, and nonbank servicers own $1.4 trillion worth of MSRs, an increase of 69% over the past three months.

“There is a large demand for MSRs because of negative duration and in today’s environment a lot of people have a large number of RMBS – so it’s an offset, a cheap hedge, compared to IOs spreads there’s a higher return,” another panelist said. “We are paid for that additional risk.

“Originators have a lot more downside when rates go up and so it’s a good asset to offset lost revenue – MSRs will appreciate when rates go up,” he said. “And it’s an opportunity to get back into origination later which hopefully will come back in my lifetime.”

Another angle is how the dynamic between prepayment risk and credit risk has changed in the space.

“We went from a market with no buyers to one or two buyers buying 13-14% unleveraged returns to where we are today,” a panelist said. “Now we’re seeing deals consistently trade between 8-8.5% yield. The credit risk isn’t major issue. With those mortgages after 2010-2012, there are not an overwhelming number of delinquencies like it was before, so now we’re trying to get the pre-pay right.

“That is the big thing for Fannie (Mae), Freddie (Mac) and even Ginnie (Mae). And it’s still a larger issue concern for us,” he said. “We are moving towards a place where there the issue of credit is less important and prepayments are more or less front and center.”

Another panelist was asked how is credit being modeled by analysts.

“When you’re modeling MSRs you only have so much capacity, so you focus on pre pays. The biggest driver of value is prepayments given mortgage rates where they are,” he said. “Prepays are the overwhelming factor. You don’t need to model that with the regulators.”

What other issues are there for those buying MSRs?

“Loan balance matters, escrow maintenance matters. As far as geography – when your escrow payments have to be made matters. You get charged interest on escrows like in California where it’s 2%. The servicer has to pay borrower 2% on escrow balance,” the panelist said. “And as we move from a refi to a purchase market we’ll see states like Texas pick up state prerepayment fees.”

Panelists said that because servicing is – as another session panelist put it – like fracking in that it’s new and there is a lot of uncertainty – due diligence as always is critical.

“For those in the servicing trade – the legacy trade is one that gets a lot of regulatory attention because you’re dealing with more delinquent borrowers and that gets a lot of scruntiny. But there are multiple levels. Who else is transacting in this space? Is servicing an actual viable entity for them to be in? How much servicing and volume do you have to put in place to cover cost of CFPB regulations?” a panelist said. “Some originators give up ghost on servicing because it doesn’t make sense.”

Basel III rules will also be an issue with MSRs, a panelist said, joking that he didn’t want to discuss Basel 3 until after a coffee break so no one in attendance would fall asleep.

“I don’t think top servicers will have a problem but a number of banks in $2 to $20 billion don’t have the resources,” he said.  “Some of that will flow into the market over the next couple of years. The absolute risk relating goes from 100 to 250% after Jan. 1, 2018. From banks to nonbanks that will cause its own set of heart burn in DC and New York.”

The panel concluded with a question no one could answer directly: How does an MSR factor in the growing regulatory costs into bids for MSRs?

“It’s a volume play. That’s the only way to make that cost become a much lower marginal variable cost,” a panelist said. “Are you bidding at a marginal cost perspective or a fully loaded cost perspective? How much of that are you going to throw into your marginal cost valuation? I look forward to pinning that down

“Clearly cost has eaten into yield but a lot of these private equity firms are using subservicing – where is the cost being borne?” he asked. “If I asked now how much of that fixed cost would you put in to that marginal cost, everyone in the room would have a different answer.”

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