Mortgage servicing rights are one of the most attractive opportunities in the market right now. There is the potential for returns as much as 30-40% IRR for the companies involved. The companies involved are not trading at premiums that reflect this; in some cases they are trading at discounts to the market (PHH Corp (PHH)) or with extremely attractive dividends (Newcastle Investments (NCT)). In other cases the companies are new initial public offerings (Nationstar Mortgage Holdings (NSM) and Home Loan Servicing Solutions (HLSS)) that so far are flying under the radar of the market.
I believe the opportunity is being ignored by a market for three reasons:
- The market lumps mortgage servicing rights in as just another housing play, and housing is still 2-3 years away from recovering
- Mortgage servicing rights are complicated and most market participants don't want to take the time to understand them
- Mortgage servicing rights have traditionally been a crappy business and over the past 5 years they have been a really crappy business
What is a mortgage servicing right?
A mortgage servicing right is a list of conditions and responsibilities that are completed in return for a payment.
I'm going to simplify the details, but essentially here is how it works. When a mortgage company originates a loan, along with the note that binds the borrower to making payments, they get a right to a tiny sliver of interest that will be paid in return for making sure that the money gets from the borrower to the lender, along with some other responsibilities, most of which deal with what happens in the case of delinquency. Usually this sliver of interest is around 25-50 basis points. This means that a loan for $200,000 will include the right to receive $250-$500 a year in return for making sure that the money gets collected from the borrower (among other responsibilities).
It's that sliver of interest that is paid in return for the collection and other servicing duties that is called the mortgage servicing right.
As a mortgage originator you have two choices of what to do with the mortgage servicing right. You can keep it, in which case you will collect the sliver of interest from now until the mortgage is either paid off or defaults. Or you can sell it to someone else in return for cash up front.
Traditionally it has been the preference of small originators to sell the mortgage servicing right for cash up front. Origination is a cash heavy business and managing cash flow is key. So while it might be nice to have a steady monthly income flowing in from the mortgage servicing right , typically the more immediate concern is getting cash on the books right now.
When the originator sells the mortgage servicing right up front they receive a servicing release premium. This sounds like a complicated term but it's not. All a servicing release premium is, is a lump sum payment that is paid in return for the stream of cash flows from the mortgage servicing right that you are giving up.
If you are interested in an even more detailed explanation of a mortgage servicing right, there was an excellent discussion paper put out by the Federal Housing Finance Agency that is accessible here.
The collapse of the Servicing Release Premium
Of course, to make it worth your while to sell the mortgage servicing right you need to get a decent amount of cash up front for it. Traditionally servicing release premiums have fetched in the neighborhood of 4x to 6x the underlying mortgage servicing right yearly payment. Going back to our theoretical mortgage above, if you were receiving $250 a year from the mortgage servicing right, you might have expected to fetch $1000 (or maybe even $1500 if you are lucky) up front for that income stream. To the buyer of the servicing release premium it would become a good deal if the mortgage didn't go into default or get repaid for more than 4 years. After 4 years they get their money back, and every year after that they get incremental return. For you as the cash strapped originator that needs to pay your employees and keep yourself liquid to make further originations, the $1000 up front helps you pay the bills and generate further originations.
A little over a month and a half ago I wrote about a great discussion on the Lykken on Lending mortgage banking podcast. Lykken had Austin Tilghman and David Stephens, CEO & CFO respectfully of United Capital Markets, on the program for an interview. These fellows are industry experts in the mortgage servicing market. The discussion begins about a half hour into the podcast. Here is a particularly relevant comment from Stephens on the current state of the servicing release premium market:
Prior to the meltdown the price paid for a servicing release premium was generally 5x or more of the [mortgage] service fee. That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.
This comment was followed up by Andy Schell, a co-host on the broadcast. Schell said that he had recently done an analysis of servicing release premiums and mortgage servicing rights and, in his words, "I couldn't believe the numbers are so low." He reiterated that the servicing release premiums are in some cases approaching zero.
As an originator, it may have made sense to sell an mortgage servicing right in return for a servicing release premium that was 4x or 5x its value. But that no longer holds true with servicing release premiums approaching 0. Even in the case of a strong origination (a good quality loan with a low default rate) you aren't going to get more than 2x the mortgage servicing rights yearly return, and are probably going to get somewhere between 1x and 2x.
It doesn't make as much sense.
Take our example: would you give up an income stream of $250 a year if you were only going to get $350 or at best $500 for it? If you held it instead you could return double that amount in only 4 years?
Who is selling mortgage servicing rights at these bargain basement prices?
I think that there are two reasons that mortgage servicing rights are getting sold down to such low prices:
- The big banks are getting out of the business
- The little guys have difficulty getting into the business
The big banks
There are a couple of things going on with the big banks. First of all, there are regulatory capital changes about to take place that are going to affect how much capital a bank has to keep on its books to hold an mortgage servicing rights. Under Basil III, the requirements for how much capital must be held for an mortgage servicing right change dramatically:
One of the biggest changes in capital definitions for U.S. banks involves mortgage servicing rights. Under Basel III, banks will be allowed to include only a maximum 10% of mortgage servicing rights in their capital measures. Any amount above that is deducted; and then, in combination with financial holdings and deferred tax assets, that can only be up to 15% of aggregate capital. In contrast, under current rules mortgage servicing rights are included in capital up to 90% of fair value or book value, whichever is lower.
The second reason is the consolidation of the banking industry. Again referring to David Stephens, who answered the question of why the value of service release premium has collapsed as follows:
Its the aggregation of the aggregators. In 2007 an originator might have 20 take outs for the loan they produced. After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts. Recently we've seen Bank of America (BAC) and Citigroup (C) getting out of the market and you can count on one hand the number of people that account for 50% of the market. And they have their own capacity limitations. It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.
A third reason that the banks want out of the business is the way that mortgage servicing rights are accounted for. The GAAP accounting standards for mortgage servicing rights forces banks to account for them on a mark to market basis. Banks have to revise the value of the mortgage servicing right every quarter. Mortgage servicing rights are sensitive to changes in interest rates. If interest rates go down then more borrowers are, of course, going to look to refinance their mortgage. When a mortgage is refinanced the existing mortgage is paid off and the mortgage servicing right that is tied to the mortgage stops paying interest. As interest rates go down the probability of prepayment increases, and the mark to market value of existing mortgage servicing rights go down.
Banks have been writing down mortgage servicing rights for a number of years now as mortgage rates have fallen to historic lows. In addition, the banks have had to book write downs because so many mortgages have gone into default over the past 5 years. The result is that the mortgage servicing part of the money center banks balance sheets has been a disaster for years now.
If you add to the write downs the stigma of being involved too heavily with the mortgage business, you can see why so many banks are either getting out of the business entirely (Bank of America) or scaling back on the business considerably [Citigroup and JP Morgan (JPM)].
The little guys
The reason that more small originators aren't keeping the mortgage servicing right on their books is simple.
- They need the cash up front and they can't wait a couple of years to recoup it
- They don't have the cash to make the start-up investments to get into the business
We are in a period where originations are strong because of strong refinancing activity brought about by low interest rates. Somewhat paradoxically, strong origination volumes create more pressure on small originators to sell their mortgage servicing rights and realize the cash up front. Large origination volumes mean more cash turnover and one way to get more cash is to sell the mortgage servicing right.
Meanwhile the drop in service release premiums compounds the effect. Getting less cash upfront for the mortgage servicing right you sell precipitates the need to sell more of your mortgage servicing rights in order to meet your cash needs.
It is also not an easy process to get approved as a servicer if you are an originator that has traditionally sold off your mortgage servicing rights but you want to begin holding them on your books. According to Tilghman, when asked about the process:
Its not easy. Some started the process a couple of years ago, had their approvals in place for this market opportunity. It is daunting though … there is a huge backlog at Ginnie Mae and at the GSE's … the people we talk to says this is still incredibly slow and its taking months for companies to get approvals. We talked to one subservicer and he as 20 companies waiting for approvals. And frankly we are talking to 30 companies that 6 months ago weren't interest in owning mortgage servicing rights and are now looking to get approvals.
Selling at the bottom
The irony is that all this selling is taking a place at a time when underwriting standards have never been better. Again referring to Austin Tilghman:
The quality of the servicing has never been better, low interest rates, tough underwriting, good appraisals, those are the positives. [There is] a lot of potential for the servicing to gain value in the future when rates go up, but most importantly to have it in place when rates go up as a hedge against your production dropping maybe 80%.
As the servicer of a mortgage, there are 3 potential negative outcomes that you don't want to see:
- The house get sold
- The loan get refinanced
- The borrower defaults on the loan
There isn't much that can be done about number one. But two and three are functions of the market and of loan quality, and they are notably strong right now.
Interest rates are probably as low as they are going to get. This has led to the boom in housing refinancing that I mentioned earlier. The refinancing boom has been a hit to servicers who have seen their mortgage servicing rights stop paying out early and have had to make downward mark to market adjustments to their portfolio. The upside of these ultra-low rates is that new loans that are being put on the books are unlikely to be refinanced for some time. Rates are more likely to go up than down. The opportunity is there to realize servicing revenues on new mortgage servicing rights for a significant period of time.
Speaking of borrower defaults, banks were hit hard when subprime borrowers walked away from their homes. Because loans weren't getting paid, neither were the servicing fee. Compounding the problem, servicing rights often have clauses whereby the servicer incurs additional responsibilities when the borrower goes into the foreclosure chain.
Now we have the opposite scenario. Lending standards are so tight that only the most fool-proof borrowers are able to get loans. The risk of default should be greatly reduced. The result again is for the mortgage servicing right to stay on the books, paying out cash, for longer.
The risk of regulation
One of the main risks to the long term value of owning a mortgage servicing company is regulation. There has been concern that the Federal Housing Finance Agency was going to change the servicing model for agency servicing, either by reducing the fee that a servicer received or by changing the structure to a fixed fee that was independent on loan value. The Federal Housing Finance Agency put out a talking paper to talk about the proposed changes back in September of last year.
In its talking paper, the Federal Housing Finance Agency once again floats the idea of paying a set dollar amount for servicing loans, while keeping open to the idea of maintaining a minimum servicing fee model similar to the current structure, but one with a reserve account option. "The reserve account would be available to offset unexpectedly high servicing costs resulting from extraordinary deterioration in industry conditions," the talking paper notes.
There was a lot of resistance against the proposed ideas, particularly from the smaller servicers, who said that the reduced servicing premium would basically squeeze them out of the business. The Federal Housing Finance Agency recently stepped back from the proposals, but they have yet to put an end to the discussion completely. Tilghman said the following about the matter:
We are continuing to be disturbed that the Federal Housing Finance Agency refuses to clearly state the servicing compensation issue that it is off the table. The responses to their December proposal were 80% against any change or for a moderate change and yet they will not acknowledge that and continue to leave open the potential for that issue. If they understood the markets and were serious about competition well frankly that is going on as we speak, they'd provide certainty and they would kill the issues that have no substantive support.
How to invest
Finding companies to take advantage of the opportunity hasn't been easy. The two obvious one's that I have owned since the start are Newcastle Financial (which I have written about here) and PHH Corporation (which I have written about here).
There are also a couple of new IPO's for companies looking to take advantage of the opportunity. Both Nationstar Mortgage Holdings and Home Loan Servicing Solutions have had IPO's in the last month. Both companies are much closer to being pure mortgage servicing plays than is PHH Corp (which also owns a Fleet business) or Newcastle (which has a legacy CDO business).
Nationstar is a well established servicer that had been held by Fortress Investment Group (FIG). Nationstar looks to be in the same vein as PHH Corp; an originator with a large servicing business. Nationstar also has a large subservicing business, which means that they take on the servicing responsibilities for servicing rights held by other companies in return for a fee.
Fortress Investment Group is also an interesting idea. Fortress Investment Group owns about 80% of Nationstar through one of their private equity funds. There is also evidence that Fortress Investment Group's management is entering into the servicing business from other angles. I have really struggled to wrap my head around Fortress Investment Group's business and try to estimate the affect Nationstar appreciation might have on the Fortress holding company. Fortress Investment Group owns so many funds and has its hands in so many pies, its difficult to understand just how relevant the servicing business turnaround could be to them.
Finally, Home Loan Servicing Solutions is a spin-off of Ocwen Financial (OCN). Having read the prospectus, it appears that Home Loan Servicing Solutions will be a income vehicle. They are going to buy up the mortgage servicing rights currently on Ocwen's books in return for a portion of the servicing fee. Ocwen would still do the servicing on the mortgages (acting in the capacity of subservicer) and in return they would be paid a base fee plus an incentive fee that is structured to entice Ocwen to keep as many of the borrowers current as possible.
It's a similar sort of deal to what Newcastle and Nationstar are doing. Its structured a bit different, with the main difference being that the loans involved are subprime and not agency. Servicing subprime loans has an extra aspect that doesn't occur with agency loans. When you are dealing with subprime loans, the servicer is responsible for putting up money in the short term when the payments are late. This means that the servicer has to have access to a credit facility, (or some other sort of funding) that they can borrow from when they need to cover payments. And that funding costs you in interest.
The servicer is ultimately on the line for payments they put up. They are eventually reimbursed, either from the borrower when the payment is made, or from other payments in the pool if the mortgage goes into foreclosure and the payment will never be made. But they do have to put up cash in the interim.
So along with the servicing commitments, Home Loan Servicing Solutions is taking over a number of credit facilities that had previously belonged to Ocwen. In this case they are commercial paper facilities, and they provide access to the short term credit that Home Loan Servicing Solutions needs to have so it can cover any late payments to the pool. Home Loan Servicing Solutions has to pay the interest on these facilities and that comes out of their profits
So that's the downside of a subprime deal versus an agency deal. The upside of a subprime deal is that Home Loan Servicing Solutions taking a bigger piece for less up front than Newcastle did. Home Loan Servicing Solutions is getting 32.5 bps in servicing fees and, based on the December 31st estimate of fair value, they will only pay 41 bps up front. In the first Newcastle deal, which was all agency, Newcastle paid 60bps and is getting 29 bps in servicing fees. In the second Newcastle deal, which was only 25% agency and 75% private label, Newcastle paid 42 bps. Its not clear to me whether Newcastle is going to have to manage the cash on the private label, but given the cheap price I wouldn't be surprised.
There are also a number of regional banks that have been increasing their exposure to servicing. To give just a couple of examples, U.S. Bancorp (USB) just last week called the opportunity in servicing "once in a lifetime", and is jumping in where the money center banks are jumping. On the smaller side, Rurban Financial (RBNF), which is a small Ohio based bank, grew their servicing portfolio by 25% over the last year.
I am actively looking for other ways to play this opportunity. Please contact me if you have any ideas.