Like many out there, you have recently been hearing quite a bit about MSR’s. This may have sparked some questions in your mind like – Can MSRs be hedged? Do most people retain or sell MSRs? What is the difference between base and excess servicing? Or better yet, WHAT IS AN MSR?
This series of posts will help identify some key terms and calculations, breakdown how they fit into our industry, and how MSRs work.
First off, mortgage servicing rights (MSR) are contractual agreements by which a third party promises to collect and disseminate mortgage payments to an investor who has purchased the loan from an originator. It is important to know that the owner of the MSR is responsible for administrative duties such as collection and remittance of principal, interest, insurance premiums property taxes, HOA fees, regulatory reporting, credit agency reporting, loss mitigation, etc. In addition, the original owner of the MSR has the opportunity to sell the MSR to a third party or retain the MSR and service internally. Now, there are many considerations that these originators face in deciding to retain or sell (release) servicing including cash requirements, operational considerations, accounting & tax treatment, and different valuation options. A classic cash consideration is can an originator afford to give up cash today (i.e., retain servicing and give up servicing released premium today) in order to receive a cash flow (servicing income) in the future. This is something we will explore in future articles.
What we would like to explore today is the fact that an MSR is also considered a strip of interest from a mortgage loan (i.e., 0.25% of a 3.75% interest rate mortgage). The strip of interest is received by the servicer for undertaking the remittance of P&I payments and administrative detailed in the previous paragraph. Take a look at the breakdown of the interest rate below regarding a conventional loan sold to the Agencies (FNMA/FHLMC):
|Interest Rate that the borrower pays (i.e., Rate the Lender originates at)||3.75|
|Breakdown of the 3.75% Interest Rate|
|Interest rate that the Investor receives (i.e., Lender sells to Investor)||3.00|
|Guaranteed Fee charged by the GSEs (Agency Sale Only)||0.50|
For your knowledge, in regards to conventional loans, the minimum service fee is 25 bps, where any servicing fee over 25 bps is considered excess. This is slightly different with government loans sold to GNMA where the minimum servicing fee is 19 bps and any servicing fee over that is also considered excess. We will go into the differences between base and excess servicing (tax treatment) in a later session.
What we are looking to do is find the real value of the MSR. Given the multiple streams of income and cost and the potential length of time of the asset (i.e., 30yrs), the value of the MSR is derived by taking the net present value (NPV) of the servicing income, less expenses. The net present value of the MSR is adjusted by the likelihood that the loan might pay off due to a refinance of the loan or sale of home. The likelihood that a loan paying off is also referred to as prepayment speeds and it is the key driver of the servicing valuation and consider both contractual payments (P&I) as well as principal curtailments that occur over time.
Prepayment speeds are an important concept to understand when determining MSR valuation – so if interest rates rise, prepayment speeds then slow (i.e., less likely that borrower refinances or that a buyer would shop for a new home due to higher rates) and the duration and value of the MSR will increase. If interest rates lower, prepayment speeds then rise (i.e., more likely that borrower refinances) and the duration and value of the MSR will decrease. The charts below will detail the relationship between rate incentive (Original interest rate- current market interest), price and prepayment speed.
We will end this article with a simple breakdown of an MSR Valuation including components of cost and income, discounting to net present value and the final price components. Due to variability of servicing fees, a large number of market participants will actually quote MSR prices in terms of multiples (Price in basis points/net servicing fee) to have a standard comparable value. In the example below that is 0.92250 / 0.250 = 3.690.