The Emperor's New Clothes


Servicing Discount Rates Need to be Revisited

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.