The COVID-19 virus is having a significant impact on owners of mortgage servicing rights (MSRs).
Mortgage advisory firm Stratmor Group suggests MSR owners take a holistic approach in this highly volatile market, taking into consideration many factors impacting cash flows that seem to be changing every day.
In the company’s latest Insight report, Stratmor detailed the nine critical factors that MSR owners should consider in today’s market.
The first factor was the fact that the bulk market for MSRs for 2020 is very quiet because MSR buyers are faced with uncertain future prepayment speeds as a result of wider than normal spreads between mortgage rates and benchmark Treasury/LIBOR rates and origination capacity issues impacting rates.
“A few bulk MSR transactions have been consummated, mostly between hedged buyers and hedged sellers, and mostly during the first half of the quarter,” Stratmor Group said in the report.
The second factor involved the speed of prepayment.
“Current prepay speeds across all servicing portfolios are up materially year over year and March 2020 speeds will certainly exceed February speeds,” Stratmor said. “Some prepayment experts believe that March 2020 speeds will increase 40 (percent) to 60 percent from February 2020 levels.”
The third factor is that potential float income is down materially as interest rates have plummeted.
Meanwhile, future loan performance is unknown.
“Servicers are faced with uncertainty around rising unemployment and expected increases in delinquencies, leading to higher servicing costs and reduced servicing cash flows,” Stratmor added.
The fifth factor Stratmor listed was uncertain future prepayments.
“Given the presence of competing factors (the Fed lowering rates vs. lenders increasing rates to manage capacity), there is great uncertainty as to the level at which mortgage rates reach equilibrium in the coming months which will drive the level of prepayment activity,” the report said.
The next dynamic was a hedge windfall. The report noted that MSR owners using financial hedges likely are experiencing “a financial windfall” as the MSR asset has not lost as much value as the hedge instruments have gained. This is because the value of the hedge instruments tends to move efficiently with the market, while mortgage rates do not drop as far as they otherwise would because of capacity management concerns.
Portfolio retention was another major factor.
“Companies with an effective portfolio retention capability will feel less pain during this period of elevated prepayments, as a sizable number of loans are going to pay off,” the report said. “The question is whether the current servicer will be able to retain those borrowers as the percentage retained will have a dramatic impact on their overall financial results.”
The eighth element was potential margin calls on MSR hedge. MSR lenders are making margin calls on highly leveraged portfolios as the value of the pledged asset has declined significantly. The magnitude of the margin call is driven by the amount of leverage deployed, such as the loan amount in relation to the MSR asset.
“Therefore, highly leveraged MSR owners experiencing an inordinate decline in MSR value are feeling the most stress,” Stratmor said. “This will be something to watch for as the March quarter end approaches. On a positive note, the cost of MSR financing is down as a result of the lower rates.”
The final factor MSR owners should consider, according to the report, is Ginnie Mae servicer liquidity.
“Non-bank servicers of Ginnie Mae face a severe liquidity shortfall as borrowers take advantage of GSE forbearance programs and stop making their mortgage payments for a period of time,” Stratmor Group added. “Since bondholders must be paid each month, the servicer must advance the funds. As of this writing, the Fed may offer backstop financing for these advances, but the eventual outcome of this is uncertain.
“While this may seem like a risky near-term strategy, entities that are able to retain servicing today will build a potential annuity stream of servicing income which will strengthen their financial position once this refinance wave is over. Projecting the cash flow demands of the origination and servicing business in a truly stressed environment is critical. Owners of MSRs need to be hyper vigilant in order to optimize cash flows and mitigate their financial risk.”