I was talking to a mortgage banker recently about servicing and was told that, while they had considered doing so, they were not retaining servicing. This discussion fell in the category of “divine providence”, meaning that their decision not retain was simply great luck given the market conditions we are seeing now.
In fact, what was expected to be the beginning of long-term increases in rates driven by a strong economy and tightening by the Federal Reserve has reversed course resulting in one of the most impressive rallies in the bond market in many years.
In one year’s time, the 10-year Treasury has dropped almost 175 basis points completely changing the forecasts for volumes, profits, and accounting implications to mortgage lenders and servicers alike.
In early 2018, this industry was looking ahead at what many expected to be a major contraction in mortgage originations with a significant number of companies perhaps on the threshold of survival.
At the same time, some companies that retain mortgage servicing rights looked at what they expected to be a prolonged period of rising rates making the duration of the servicing they held longer than in previous cycles and therefore more valuable.
As servicing is capitalized in present-year earnings, the expected rising rate environment was seen by some as a way to hedge against anticipated mortgage production declines. It’s a pretty obvious scenario, as interest rates rose into the 4% range it meant that all of those mortgages in the 3% band were “out of the money” and were unlikely to payoff except for a few scenarios (default, cash-out refinance, home sale, or a significant lifestyle change).
Removing the rate and term refinance factor from forward-looking hedge strategies simply meant that the prepayment speeds would likely slow.
In comes global fragility, tariffs, and the downstream concerns about a weakening economy and add the increased view that this would reach the US as well.
Today, the majority of economists now think a recession is a certainty. Nearly three-quarters of economists predict the next recession will hit by the end of 2021 — including 38% who see it coming in the 2020 presidential election year, according to a survey by the National Association for Business Economics.
The outcome has resulted in a flight to quality and reduced optimism over the longer term, resulting in this rapid decline in bond yields, particularly long bonds, producing the recent negative yield curve.
So what now? The reality is that the bond market will reach a floor. And we are closer to that floor today with 10-year Treasuries in the mid-1.5% range. However low mortgage rates go, this round may be a unique opportunity for those that hold servicing or are contemplating it to double down on retaining. What was good fortune to those that held back last year may be opportunity looking forward.
The key here is to be careful about timing. While the bond market has rallied, mortgage rates may not have fully caught up. The recent rate declines have raised volumes and built-up pipelines and some lenders have held back on rate declines as they work to manage service levels and maximize profitability.
The other question to be answered is how low these rates may go. With roughly $14 trillion in global bonds paying negative yields and still unknown ramifications from trade tariffs and tweet volatility, the U.S. Treasury remains a AAA-rated option with at least some yield for investors and as cash flows into them, prices will rise and rates will at minimum stay flat or decline further.
The current environment certainly raises the need for lenders to look at their ability to retain servicing as an option. Behind rate rallies are usually corrections and last year’s concerns about survival in a low production environment can be offset potentially by the natural hedge of servicing retained.
There are headwinds to service retention beyond simply bets on duration. A slowing economy will raise default rates, even if marginally. The cost of managing default servicing is extremely expensive and one that needs consideration. For nonbanks and others without substantial balance sheets, advances to mortgage-backed securities holders, particularly in the Ginnie Mae program, could become expensive and the need for liquidity will be paramount.
If that is in a rising rate environment or simply a tightening of available liquidity, it could pose institutional risks to some.
I reached out to Seth Sprague from the Stratmor Group and he made some key points, saying “It is very important that companies retain the servicing that is consistent with their overall operations and servicing strategies.”
He went on to suggest focusing on things like low loan balance, a market that has pretty hot specified pool competition already and to look at avoiding loans that might have higher default rates such as those serviced for Ginnie Mae products.
Seth adds, “the majority of the large bank MSR portfolios have a weighted average coupon around 4%, and the latest drop in rates brings a larger percentage of their MSR portfolios in the money to refinance.” I note here that even the best at efficient refinancing run at perhaps 35% replenishment rate making this a costly write down for some as rates decline.
I spoke to another highly respected CEO in the industry and he had some sage advice, suggesting that for independent mortgage banks without access to a balance sheet, the liquidity challenges will be great.
He cautions that the likelihood of recession is high and suggested that the current rally is a “sugar high,” but once the refinance-able coupons are burnt out it will be a tough market. He suggested that if you are going to entertain engagement, partnering with a bank or a platform with a steady and firm commitment to supporting you through a down cycle will be important. He added, “stay away from lower FICOs”, implying that the cost of default management in this next recession will be high.
These servicing questions are tough decisions to be made by lenders in a complex business environment but may pose opportunity for some. My recommendation is to talk to experts in the field, retain advisors, and develop your plan to retain in order to at least be prepared to execute when it seems optimal. Whether you retain or not at that point, at least you will have had the option to make that decision.