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Jul. 5, 2011: The Value of Servicing Explained
Rob Chrisman
[I am
away from the computer on a daily basis, and my access to e-mail
is sporadic and not timely. In my place are daily commentaries
from a series of very knowledgeable mortgage industry people
with different backgrounds, and they have been given very little
direction about what to write about – the latest is below. Our
views may or may not coincide, but I thank them for their time
in volunteering and helping out.]
One thing that I am
always asked about is the value of servicing. Let’s break apart
the price of a mortgage loan into a few components. At a very
simple level, a mortgage is a loan for a home and that home is
used as collateral. These loans are pooled into bonds called
mortgage backed securities. These bonds are rather large, and
an institution that holds a bond doesn’t want to collect and
process hundreds of payments ever month from John and Suzie
Borrower. The solution is to have a servicer handle the payment
collection and other clerical tasks involved in mortgage
lending. Also, the holder probably purchased the bond because
there is some level of guarantee from an agency like FNMA.
These two things, servicing and bond guarantee, are very
important aspects of mortgage banking as they add liquidity to
the loans we originate.
All residential
mortgage loans can be broken into different value components.
The security piece, the servicing, and the guarantee fee are the
three most important components. The security piece represents
the majority portion of the loan and it is owned by the security
holder. The servicing piece, often a .25% of the interest rate,
is paid to the company who collects and remits borrower
payments, manages escrow accounts, handles collection and
foreclosure issues, etc. Most Agency products go into Mortgage
Backed Securities (MBS) and are backed at some level by one of
the Agencies (FMNA, GNMA, and FHLMC). The Guarantee Fee (GFee)
is the Agency’s cut of the transaction. Below is an simplified
example of the value components of a 5.375% 30 Year FNMA loan.
5.000 FNMA
Security
0.250 Servicing
Fee
0.125 G Fee
5.375 Note Rate
The security value is
determined by the market just like the price of a stock. The
guarantee fee is set by the contract between the lender and the
investor and/or Agency. The value of servicing…well that is a
bit more complicated. The value of servicing is the price at
which a servicer will pay for the right to service and collect
the servicing fee over the life of a loan. There are plenty of
variables that make this estimation of future cash flows
difficult. Most importantly, how long will a loan or a pool of
loans last? Second, what fee income can a servicer derive from
the loan(s)? Finally, what are the costs to service this loan?
If one can answer these questions, then anticipated revenues and
costs can be used to create a future cash flow model that can be
discounted to present value dollars. Without a crystal ball
however, assumptions have to be made in order to create these
models.
These models are very
complex and analysts try to adjust for the many variables that
can affect these future cash flows. One could right an entire
book on the valuation of servicing. For purposes here, I
believe we should focus on the following three variables.
The most significant
factor that affects value of servicing is runoff. The longer a
mortgage pays monthly without paying off, the more cash flows
the servicer collects. A mortgage can pay off at any time, and
when it does the servicing instantly becomes worthless. Simply
put, the longer the servicer collects fee income, the more money
the SRP is worth. So what does a servicer use to estimate the
life of a loan? The first thing is the interest rate of the
loan in relation to the market rate. A 5.00% loan in a 6.00%
market will likely have a longer life than a 6% loan in 5%
market. The other is socioeconomic and real estate law trends
that tend to fall within state lines. In
general, all other things being equal, borrowers in
some states are more sophisticated than borrowers in other
states and will tend to refinance quicker. Also, there are
state laws that cause some portfolios to runoff slower. For
example, Texas state law makes it more difficult for a borrower
to refinance to get cash out. Another factor is the cost to
refinance. In Texas, title insurance is very expensive while
costs to refinance in Colorado a relatively low. Servicers
continually back test their portfolios and use historical payoff
speeds to determine which states runoff fastest.
The second factor
affecting the value of servicing is the float income earned on
escrow balances. When are borrower makes his or her PITI
payment to the servicer, the taxes and insurance go into an
interest bearing account until the taxes and insurance are due.
Insurance is almost always paid annually and therefore the
insurance escrow balance will average 6 times the monthly
insurance payment over the year. The taxes that are put in
escrow also build up over time. The average balance of taxes
depends on how often they are paid to the state. In Texas,
taxes are paid annually and therefore there is an annual average
balance of 6 months taxes. With the 1-2 months cushion, the tax
multiple for Texas is 7.5, the highest of all
states. Additionally, some state laws require the servicer pay
the borrower interest for the money sitting in escrow, and as
you can guess this hurts the servicing value in those states.
Lastly, the amount of taxes collected varies by state. Again,
Texas has an SRP advantage due to comparatively high percentage
Texans pay in real estate taxes. If you have ever wondered why
you are charged a .25 to waive escrows, it’s due to the loss of
expected float interest on escrow funds.
The third factor is
delinquencies. Obviously a delinquent loan is more costly to
service than a good performing loan. If a loan ends up going
into foreclosure, the servicer’s costs skyrocket. Not only due
delinquency trends follow state lines, but foreclosure laws
differ amongst states and therefore so does the costs of
foreclosure. One side note - you will see that delinquencies
can affect government SRPs more than conforming do to remittance
differences. On government loans, the servicer has to remit
P&I to the security holder whether or not the borrower has
made their payment. If you own a highly delinquent GNMA pool,
you can run through your cash pretty quickly while advancing
P&I payments for all your delinquent borrowers. Florida is
an excellent example of this. Delinquencies have run very high
in Florida of the last few years, and during that time we have
seen a significant decrease in Government SRPs but only a slight
decrease in Conventional SRPs in this state.
As I mentioned
earlier, servicing valuation models are extremely complex and
contain many more variable than just the three above. I
discussed these three topics as they have a significant impact
on servicing values, and they also help explain why loans from
one state are valued higher than similar loans from another.
Chris Cordry
PrimeLending, A
PlainsCapital Company
VP Secondary
Marketing
If you’re interested,
visit my twice-a-month blog at the STRATMOR Group web site
located at www.stratmorgroup.com . The current blog
takes a look at near-term news for non-agency securities, such
as jumbo residential loans. If you have both the time and
inclination make a comment on what I have written, or on other
comments so that folks can learn what’s going on out there from
the other readers.
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