In the previous article, MSR 101: Let’s Get Back to the Basics we went into what MSRs are in this current economy and how to read rate move and price change. But, before we can move further into more specifics regarding Mortgage Servicing Rights (MSR) valuation assumptions, we need to discuss the different types or flavors of MSR valuations. Understanding the types of MSR valuations will drive modeling decisions made by you and your MSR analysts so that you can decide when to include float or ancillary income. Being able to differentiate between types of valuations will also help you determine when to use each MSR valuation type and the pros & cons of each.
Let’s take a step back here - where do you go when you need to find out the price of a share of Apple? There are a variety of financial websites including news sites such as Yahoo Finance, Broker or Trading websites such as E*TRADE or apps on your iPhone where you could find an up to the minute price on the stock of the Apple, all which indicate the recent trade activity which is the published price. Obviously, this is not the case for price discovery for MSRs. Due to the lack of transparent pricing in the MSR market, there is no better indication of the value of an MSR than an actual trade that has been transacted which is an indicator of the Market Valuation.
The market valuation is meant to replicate an actual trade between a “willing seller” and an “informed buyer” in an active marketplace. In other words, the assumptions used to model a MSR should closely match similar deals done recently in the marketplace. To simplify this idea, if a recent MSR pool was sold at a price of 0.95, the MSR modeler using a market valuation should aim to have his valuation be relatively close to the price of 0.95, provided that the under lying loans are of a similar makeup. Due to this nature, it is possible that the assumption used to model market valuations can actually differ from a lender’s actual economics. Market assumptions such as float rates, ancillary income, late fees, and servicing costs can differ materially between different lenders and investors.
Market valuations are subject to more volatility as supply and demand fluctuate due to external factors such as company earnings, market liquidity, and counterparty risk. For example, if a handful of MSR investors exit the marketplace or lower their bids due to external factors this can lead to lower market valuation despite the actual economics of the MSR portfolio barely changing. An MSR investor could lower their bid at the end of the month or quarter due to lower capacity from winning multiple bids earlier in the month. Due to examples like this, calibrating assumptions to actual trade activity can lead to extreme or conservative valuations due to heavy impact of market timing and supply/demand concerns. With the difference in valuation assumptions between a lender’s actual economics and market assumptions, there could be a valuation gap between the actual revenue from a servicing a mortgage and the value of the MSR capitalized for accounting purposes.
The Economic Valuation uses a lender’s actual information from their subservicing contract or actual economics (i.e., cost of funds, ability to earn ancillary income) to value the MSR. In other words instead of using market assumption for a recent transaction, the MSR modeler would use assumptions derived from the lender’s actual business plan, economics, or sub-servicing contract. If a lender’s MSR contract stated that all late fees collected for a borrower’s mortgage payment being delinquent where returned to the sub-servicer and not the lender, the lender would not model late fee income in this valuation scenario. Please see an example below where late fees collected are not included (Economic) and included (Market). The inclusion of late fees collected could lead to almost 10 bps in valuation!
When modeling the economic valuation of an MSR there are some additional concepts to be aware of – Ask yourself, what is your strategy when it comes to holding MSRs (i.e., retain for X amount of months and then sell bulk or retain in perpetuity)? Based on your holding strategy, your assumptions can differ based on the different internal rate of return achieved per holding strategy. Where does your sub-servicing contract or internal economics differ from the marketplace? Many sub-servicers do not pass on float earnings while a potential investor in MSRs can potentially earn float. Could your business model materially differ from an MSR buyer? The classic market vs economics assumption difference is the ability to earn ancillary income also known as the ability to cross sell different products to a customer. For example, an independent mortgage banker may not have the ability to cross sell where as a depository institution can cross sell different products to a borrower such as a savings account, a car loan, or a line of credit.
Now that we understand the differences between market and economic valuations, the big question is- when should MSR modelers use each type of valuation? When it comes to making the decision to retain or release servicing, it could make sense to use a market valuation. During a loan sale, a Secondary Marketing Manager will be evaluating co-issue grids, direct trade/AOT models, bulk bids from Aggregators, and an internal retained valuation. This is effectively the market for servicing! If you are using an economic valuation during a loan sale you could be adversely selecting release valuations and missing out on increasing your MSR portfolio. An economic valuation can be useful when running a monthly valuation on an MSR Portfolio when a more conservative valuation is desired.
Put any questions or thoughts you have in the below comments section and stay tuned for our future MSR primer articles!