Filed under: Mortgage Rates, Mortgage Servicing Rights, MSRs, Prepay Speeds | Tags: healy, level 1 loans, mortgage rates, MSR, Servicing, Servicing Rights, Thomas J. Healy, Tom Healy, valuation
The interest rate decline has not been kind to those who own mortgage servicing rights. As interest rates dropped, prepay speeds soared, and values plummeted. As can be seen from the graph below, all of the major servicers experienced significant declines in servicing values over this period (source: 10Qs).
It is most probable that we will eventually enter a period of increasing rates. This is a time when the servicing asset really proves its worth. It is also the time to prepare for the next rate downturn. Discount rates (yield requirements) in our industry have always been “sticky” as rates rise. As mortgage rates rise, discount rates increase, but nowhere near enough to take into consideration the rapidly growing risk that rates will eventually come down once again. The yield that we require needs to increase appreciably as rates rise to compensate for this increasing payoff risk.
The two largest drivers of servicing values are prepayment speeds and discount rates. There is always a great deal of attention focused on prepay speed projection methodology, but much less on the discount rate. The discount rate should reflect the return we demand on this investment. The rate currently used is often either subjective or based on rudimentary rubrics such as an x spread over a 10 year Treasury. A more logical approach to deriving this rate will not only make it more defensible to auditors and regulators, but can also be constructed to prevent large write-downs in the next interest rate decline.
As with any other investment, the discount rate should reflect the returns we could receive on other alternative investments plus or minus increments for the various risk elements unique to the servicing asset. In the author’s opinion, the basis for the discount rate should be the mortgage rate, not the 10 year Treasury. Mortgage rates are more easily tailored to the characteristics of the servicing portfolio (e.g. 30 year, 15 year, 5/1 ARM, etc), are readily discoverable, and already reflect many of the risks inherent in the servicing asset.
The mortgage rate, however, does not exactly reflect all of the risk dynamics of the servicing asset. For instance servicing has additional operational risks and is a less liquid asset. It also could be argued that, in most cases, its credit risk is less than the underlying mortgage (absent repurchase risk). It has a similar maturity risk to the underlying mortgage but, because of its negative convexity, has a much greater volatility of return as expected maturity ebbs and flows. That is, when rates drop and prepay speeds increase, the mortgage investors at least gets their investment back (more or less), while the servicing investors’ cash flows simply stop.
Given today’s somewhat limited market for servicing, it appears that this spread over mortgage rates for newly originated, 30 year, fixed-rate, agency servicing approximates 450 basis points. This would put today’s base discount rate in the 8.5 – 9.0% range. While this spread needs to be tested regularly, it should be a fairly constant function throughout an interest rate cycle. It is the maturity risk that needs further focus.
If you look at the period between January 2000 and December 2011 (right), mortgage rates had a peak of 8.33% and a trough of 3.96%. While this range of rates is nowhere near the range from its historical peak (mortgage rates hit 18.45% in October of 1981), it is still a wide enough rate swing to cause great consternation to holders of mortgage servicing rights. (source Freddie Mac PMMS)
If you were to accept that a reasonable range of expected mortgage rates through an interest rate cycle is 4.5% to 8.0%, I would make the argument that the higher the current market rate when the loan is originated, the higher the probability that it will experience a lower rate environment at some point during its life. Thus the riskiness of a higher coupon loan (i.e. its potential volatility of return), is greater than a mortgage originated at the low point of the interest rate range.
In fact, if I value a 5.1% thirty year, fixed rate, conforming mortgage as of April 2010 (current market rate at the time), I get a value approximating five times service fee. This is probably what the MSR would be booked at as of that date. Unfortunately, subsequent to April, the market dropped to a low of 4.23% in October of that same year. Accordingly, the valuation of these same loans dropped significantly, creating the potential for a significant impairment over only six months.
I looked at this phenomenon over all coupons (in 50 basis point increments) from 4.5 to 8.0%. The results are below. If the same loan as mentioned above were valued using discount rates and prepay speeds in common usage at the time the coupons were “market”, I get a range of values from a 5.0 multiple when rates are low, down to a 4.5 multiple when rates are high.
The problem comes in when rates migrate to the low end of their cycle. As can be seen below, the higher coupon loans (8.00%) lose approximately a full multiple (or more) in value dropping to 3.44, while the lowest coupons lose nothing (as would be expected).
Unfortunately, the solution is to recognize this phenomenon at the time of booking the servicing asset. At a current mortgage rate of 8%, there is substantial maturity risk. It takes an additional 9.0% over and above the regular discount rate to adequately take this potential rate drop into consideration (see below).
I would not conclude, however, that in reality this full 9% needs to be added to the discount rate. This is the extreme and assumes that rates drop to 4.5% overnight. This has never happened. Rates tend to migrate up and down rather than soaring or plummeting overnight. Because servicing cash flows, and its economic benefits, are heavily skewed to the first three years of a portfolio life, you may feel comfortable with a much smaller “option spread”.
Option risk increases as rates rise and needs to be taken into consideration. Because we do not know when rates will rise or fall, it is a projected volatility that can be addressed in our yield requirement. Now is the time to start reflecting this in capitalized value, while we are still in the trough of the interest rate cycle.
Filed under: Mortgage Markets, Mortgage Servicing Rights, MSRs, Prepay Speeds | Tags: healy, level 1 loans, mortgage rates, MSR, Servicing, Servicing Rights, Thomas J. Healy, Tom Healy, valuation
As anticipated, MSR prices, as of September 2011 10Qs, are down once again.
Filed under: Mortgage Markets, Valuation Tools | Tags: Basel III, healy, MSA, MSR, Servicing Rights, valuations
The proposed capital rules under Basel III would limit capitalized mortgage servicing assets (MSAs) to essentially 10% of Tier 1 capital. This could adversely impact servicing market values. Accordingly, I took a quick look at whether or not there may be a problem. My conclusion is that there may be some dislocations at the bank level, but there is not a substantial systemic risk to servicing values.
There were 7,941 banks and thrifts in the United States as of 3/31/2010. Of these, 1,137 had capitalized servicing (MSAs) on their books. 67 of these institutions had MSAs that exceeded 10% of Tier 1 capital, the remaining 1,070 were under 10%. The bad news is that in order to reduce their MSAs to 10%, the 67 institutions would need to reduce their holdings by $24.8B. This equates to approximately $2.8T of mortgage servicing principal balance at an assumed value of 90 basis points. The good news is that the remaining 1,137 institutions, that are under 10% concentration, have adequate capital to absorb essentially all of this $2.8T ($2.6T anyway) if so desired. This assumes that the banks that currently have no servicing wish to remain that way (a good bet for the most part). It also assumes that non-bank mortgage servicers will not absorb some of this product. This is probably not the case.
There are several ways an institution can address their overage:
- Sell part of the portfolio – Only 28 of the 67 “over limit” banks are over by greater than 10% of Tier One capital and may need to sell. Their overage aggregates only $350B of servicing principal balance.
- Accelerate amortization and sell more loans servicing-released – It is conceivable that the other 39 institutions will manage their concentrations down through a more accelerated amortization combined with more servicing-released sales. Additionally, normal prepayments and curtailments will also reduce their exposure materially before the proposed regulations take effect in 2012.
Implementation of these capital limits, while non-sensical, should not create a large supply/demand imbalance and, therefore, should have little impact on servicing value.
NB … please let me know if you would like to see the bank level data that went into this analysis. Also, I would appreciate your thoughts on this subject.
Filed under: Valuation Tools | Tags: convexity, financial assets, healy, level 1, mortgages, oas, valuation, valuations
Option-adjusted spread (“OAS”) analysis is not well understood by our industry. OAS should not be used to generate an assessment of value but, rather, as a very useful output of the valuation process. It is an important financial tool that adds tremendous insight into the risk dynamics of mortgage related assets, but it does not produce a market or economic value.
The process of developing an OAS is very telling:
- Generate a large number of randomly generated future interest rate paths;
- Produce cash flows along each path at a risk-free rate plus a spread;
- Obtain a simple average of the net present value of these cash flows;
This produces a simulated price.
- If this simulated price does not equal the market price, choose another spread and rerun;
- Repeat this process until the simulated price equals the market price
The resultant spread is the OAS. This OAS is calibrated to market value; not the other way around.
The current usage of OAS analysis as a tool to determine price implies that we know the risk spread that the market demands and, thus, can use this spread to determine price. This is intellectual hubris. The spread is predicated on a large number of very complex assumptions and models, few of which are directly observable in the marketplace. These assumptions include, but are not limited to:
- Rate volatility (the speed at which future short rates change from their current implied values
- Rate constraints (high/low)
- Mean reversion properties
- Distribution (normal or log normal)
- Yield curve model (instantaneous forward rate or short rate)
- Interest rate path generation (single or multi-factor)
Additionally the OAS, while ostensibly a stochastic measure, is heavily influenced by a deterministic prepay model. While most analysts would test their OAS with sensitivities based on 90% or 110% of these prepay models, this simply “measures the sensitivity of OAS to consistent misestimation of the prepayments … not to random fluctuations around the model’s predictions.”[1]
And, even if these assumptions were observable and defensible, the option adjusted value is still meaningless from a valuation perspective. It is an average of hundreds of different interest rate paths. Possibly one of them is the correct path (i.e. what actually occurs), but there is no assurance that this is true, nor is there even a meaningful probability that this path is the “average” path that the OAS concludes. “It is extremely unlikely that a security will actually earn its calculated OAS.”[2]
If you look at the distribution of values that an OAS analysis produces, you will see my point. A greatly simplified example is shown below. 
This simplified example shows only five possible outcomes: a yield on the investments of: 0%, 7.5, 15, 22.5 or 30%. The model generates a frequency distribution of these returns as indicated from a low of 3% to a high of 40% (naturally they sum to 100%). As is typical with mortgage related investments, the distribution is not normal; it is negatively convex (skewed to the left). Because an OAS value is a simple average of values over the entire distribution, the OAS value in this case would result in an average return of 15% (the “mean”). Not only is this value far from a certain outcome, but it is not even the most probable outcome. The most probable outcome (the “mode”) returns only 7.5%.
I would not pay a price that equates to a yield of 15% when the most probable outcome is a yield of 7.5%. Additionally, I would look closely at the dispersion of the expected returns emanating from these hundreds of paths. If the deviation around the mode is small, I may be willing to pay the price related to the modal price (never the mean price). If the dispersion, however, is large, I would discount the price substantially.
OAS provides very useful information about the expected cost arising from the mortgagors’ ability to prepay at will. It does not, however, measure credit risk nor does it provide the answer to the question of “what is the value of this asset”?
OAS has become a fad; one number that ostensibly summarizes the entire range of financial dynamic of the mortgage asset. Yet this is not what the architects of OAS intended. They never “intended the OAS to be viewed as a ‘yield takeout’ over Treasuries. Because it’s the result of an averaging process.”[3] Financial analysts love to talk about OAS while disparaging scenario and other analyses. Yet, from a market value perspective, OAS is a very elegant and expensive way of being wrong.
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N.B. Blogs do not allow for a lengthy discussion of any subject. I will be publishing a more comprehensive discussion of this topic in Mortgage Banking Magazine and will advise those who are interested as to its publication date.
My next blog will address level 1 (under FAS 157) alternatives to valuing mortgage related assets. This will not be available until the first week of September. For the remainder of this month I will be focused on producing an article for Mortgage Banking Magazine (October 2010 edition) on identifying paradigm shifts in our industry before they wreak their havoc on us.
[1] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 45
[2] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43
[3] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43
Filed under: Credit | Tags: credit, mortgage, mortgages, pricing, residential mortgage pricing
Everyone knows there is a relationship between the cost of a mortgage loan and the borrower’s credit strength. The precise relationship, however, is less clear. Lenders expend a great deal of resources to determine the true cost of defaults so that their pricing is accurate on a risk adjusted basis. Level 1 Loans has examined seventeen of the largest lenders’ rate sheets to quantify the effect that credit scores and loan-to-values have on their pricing; all other product characteristics were held constant. We examined the pricing of a hypothetical loan with the following characteristics:
- $300,000 principal balance; 1st lien;
- 4.50% fixed rate coupon; 30 year term;
- Collateralized by property located in Ohio;
- Full documentation; conventional
We looked at pricing from our database of the major aggregators’ product offerings, underwriting guidelines, stipulations and rate sheets. This data is updated daily. The results (below) show a spread of 310 basis points between the highest price offered for this hypothetical loan (102.17 @ 60% LTV & 780 FICO) and the lowest (99.07 @ 95% LTV & 620 FICO). As can be seen, this is not a linear function. In fact, pricing is almost flat for FICOs >= 720 with LTVs >= 65%. Below this 720 threshold, however, the expectation of losses climbs and prices plummet.
Loss expectations are driven by the probability of default (PD%) and the severity of a projected loss, i.e. the loss given default (LGD%). While mortgage lending is a behavioral science, and many demographic factors relate to mortgagor defaults, we have limited this review to loan-to-value and credit scores. The PD% is primarily driven by credit score, while the LGD% is more a function of LTV; although the two are inextricably intertwined. Credit scores have minimal impact on pricing at the lower LTVs (62 bp swing @ 60% LTV) while they influence pricing by 285 bps at 95% LTV. Likewise, LTV variations have de minimus impact on pricing (26 bps) at credit scores over 720 but a 248 bp swing in pricing for the lower credit score mortgagors.
On a $300,000 loan, a swing in pricing of 310 basis points implies expected losses of approximately $9,300. This expected cost is passed onto the mortgagor in terms of either upfront points and/or a higher coupon.
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For additional information please feel free to access our daily database of loan pricing indices (LPI) at www.L1Loans.com
Excerpts from: “Analyzing Home Price Trends: Do Real Estate Values Always go Up?”
Secondary Market Executive; January 2006; Dr. Thomas J. Healy CMB
- Modest Household growth – Goldman Sachs economists have pointed out that investment in residential real estate is at a 40-year high, yet the number of households is growing at its slowest pace in 40 years. This may very well create excess supply.
- Easy money – According to the Economist (6/18/05), 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchases last year. Additionally, homebuyers can get 105% loans to cover buying costs. And, increasingly, little or no documentation of a borrower’s assets, employment and income is required for a loan.
- Innovative Products – Interest-only, multiple payment option, forty year term and negative amortization loans also add to the home-buying and refinancing exuberance. Over 60% of all new mortgages in California, and one-third nationwide are interest-only or neg-am. Also, these exotic products are usually adjustable-rate mortgages (ARMs). ARMs have risen to half of all mortgages in those states with the largest price increases, which may present difficulties when interest rates start to rise.
- Interest rates — Given today’s historically low rates, there may be more opportunity for rates to rise than for them to fall. If that is in fact the case, mortgagors’ payment percents must rise (unlikely due to the large percentage of disposable income already consumed by housing), or real estate price multiples must fall.
- Investor owned properties – There are increasing numbers of Americans that are buying houses for speculative purposes. That is, they are buying them to flip under the assumption that housing prices will continue to rise. Fully 23% of all purchases in 2004 were by investors. In Miami, one-half of all condominium purchases were by these “flippers”. While economists such as Karl Case believe that bubbles don’t burst, rather they deflate due to “downward stickiness” of prices (i.e. when demand dries up, potential sellers simply hang on and wait for prices to rebound), investors are not so constrained. As rents continue to under-perform relative to housing prices, investors will be under increasing pressure to sell … at any price.
- Values to rents – “An asset derives its value from the income that it will throw off in the future. With a stock that means the dividends it pays, with an owner-occupied house, it’s what economists call ‘imputed rent’- what you would have to pay to rent an equivalent house.” (Justin Fox, Fortune 6/13/05). There is currently a diverging relationship between house prices and rents. “To bring the ratio of prices to rents back to some sort of fair value, either rents must rise sharply or prices must fall. …For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America’s ratio of house prices to rents back to its long-term norm.” (The Economist, 6/18/05)
The presence of real estate bubbles in the United States can have significant impact on our industry and economy.
- Roughly two-fifths of jobs created since 2001 have been in housing-related sectors such as construction, real-estate lending and brokering. If house prices fall, this boost will turn into a substantial drag.
- The mortgage industry is dependent upon a series of explicit and implicit: guarantees, credit insurance, liquidity agreements, and the expansive derivatives marketplace to thrive. A broad-based real estate bust could strain this infrastructure.
- The real estate bubble has fostered household over-borrowing and over-consumption. Given the high average level of personal debt relative to personal income, an increase in bankruptcies is likely. Personal consumption expenditure, which has driven the economy so far, may drop.
Filed under: Mortgage Markets | Tags: call reports, delinquencies, mortgage, mortgages
The 10 year Treasury rate inched back up another 8bps to 3.39%; although the 30year mortgage rate did not follow, remaining essentially flat. The bigger news, however, is that that 10.5% of those that already have bank-owned mortgages (approximately $2.5T) have decided not to make their payments. As the graph below shows, March 31, 2010 call report data shows that delinquencies continued their inexorable climb.
The 10 year Treasury rate inched back up to 3.31% from 3.25% a week ago. Correspondent mortgage rates rose as well; although by 14 basis points. Retail rates lagged in their response to this uptick in the market and dropped slightly (6bps) to 4.78%. The resultant spread between the primary and correspondent rates is down to 18 bps; unsustainably low. I would expect this spread to get back to a more normal 25-30 basis points next week.
Filed under: Mortgage Rates | Tags: mortgage rates, mortgages, Thomas J. Healy, Tom Healy
Very interesting week! The stock market plummeted bringing the 10 year Treasury rate down with it. The 10 year ended the week at 3.25%, down 31bps from a week earlier. As might be expected, mortgage rates dropped as well. Correspondent mortgage rates came down 21bps to 4.46% while retail rates dropped only 9bps to 4.84. It is not unusual to see this kind of lag between the index rate (treasury), the secondary rate and the primary rate. I would expect some catch up next week.
Very little change in rates this last week. The correspondent par mortgage rates dropped by a little bit under 1 basis point over the last week ending at 4.67%. This despite a small increase in the 10 yr treasury (increased from 3.41 to 3.56%).
The jumbo market continued to lose luster with spreads to comparable conforming product increased from 207 to 235 basis points; almost back to its pre-Redwood securitization level.
NB. For daily pricing on a more diverse set of loan programs please visit Level 1 Loans Index or visit us at Booth 109 during the New York Secondary conference.
