The Emperor's New Clothes


Refi’s Wreak Havoc on MSR Impairment
July 10, 2012, 3:21 pm
Filed under: Lessons Learned, Mortgage Servicing Rights, MSRs, Prepay Speeds

This has been a difficult year for servicers.  In addition to increasing costs and ever more regulatory burdens, we continue to see most of our new servicing coming from refinancings.  For the majority of servicers that do not utilize fair-value accounting, this can result in bloated temporary impairment reserves. This temporary impairment is really permanent, and should be written down as the loans pay-off.

From an economic perspective, refi’s are not beneficial to the servicing industry.  While the new loan added may be slightly more valuable than the pay-off due to higher balance, lower coupon and extended maturity, the increased value is oftentimes offset by the cost of paying off the old loan and setting up the new. 

Yet from an accounting perspective, many servicers add the value of the newly originated MSR to their capitalized servicing and continue to amortize the capitalized servicing on the old loan.  The theory behind this is that the amortization already reflects the expectation of premature pay-offs and thus, to write-off the loan, is redundant.  This, however, creates the opportunity for impairment when refi’s make up the preponderance of new originations.

To illustrate this, I took a hypothetical portfolio of 2,500 loans ($550MM) and valued it over six periods.  Each period has the identical prepay and other assumptions as the last.  Accordingly, the overall value hovered around 1.0% (5.5MM).  However, in each period I assumed that 100 loans refinanced.  The new loans have the identical characteristics as the old loan except for the origination and maturity dates.  Accordingly, the current principal balance of the servicing portfolio does not change over the time period reviewed.  The value remains relatively constant over time,  diminishing only slightly as the portfolio ages.  Basis equal to the fair market value of the new loans was added in every period, and amortization was calculated based on the portfolio’s decreasing economic life. 

The analysis was run twice: first with no write-off of the basis (“amortization only”) on the paid-in-fulls.  Amortization is thus relied on to keep the basis in line with market value; and second, with a “write-off” of the paid-in-fulls’ bases as the loans are refinanced.  The differing results are dramatic.

Amortization Only – The red line on the graph below shows the rapid escalation of basis as new loans, and their respective bases, are added.  This is, admittedly, an extreme scenario.  I have assumed a high volume of pay-offs, all of them are refinances, and 100% of the refis are recaptured by our hypothetical mortgage servicer.   It is clear why the impairment is growing so rapidly in this scenario.  The growth in basis is substantial and, while amortization is growing as well, the net of the two fails to adequately reflect the fact that the market value of the portfolio is essentially unchanged over this time period.  Since market value of the overall portfolio is essentially static, impairment grows exponentially. 

Write-off – Comparing that however, to a Write-off scenario, where the basis on paid-in-fulls are written down, the dynamics change dramatically.  The green line in the same graph shows the basis as adjusted for the write-off of the old refi’d loan.  As is evident, there is no impairment under this scenario.  The “write-offs” are simply recognizing as a permanent impairment that which would be considered temporary under the Amortization Only method.  Since the resultant basis is lower, this approach has the additional benefit of reducing amortization going forward.  Over time, there is no difference in the two methodologies.  100% of the basis will be written off eventually, it is just a matter of when and how. 

Writing-off the basis on loans that have refinanced may not be popular with the folks in originations.  After a particularly good month of originations, no one wants to hear that the net effect on the bottom line approaches zero.  However, we are deluding ourselves, in a high refinance environment, in thinking we are making progress.  The refinance business, from a servicer’s perspective is at best a zero sum game.

The mortgage industry’s growth has historically been driven by population growth and real estate appreciation.  In this growth scenario it may be defensible to add the basis on the purchase money loans added and rely on amortization to reflect pay-offs.  Neither is the case today.  Absent immigration, our population is expected to be stagnant through 2050, and real estate values continue their inexorable decline towards more sustainable levels.  Our total industry servicing rights accordingly, are not growing.  We are simply moving them around from one company to another.  In this environment, it is prudent to write-off loans that that have refi’d.

 As published in Mortgage Banking Magazine, May, 2012



Discount Rate Is Often Misused

Every finance student has been exposed to the concept of the time value of money.  They learn how to calculate the net present value (NPV) of even and uneven cash flows and the importance of the discount rate.  This rate is synonymous with your required yield and is often tied to a market rate of a comparable asset plus or minus some risk spread.  This is normally further adjusted to insure that minimum corporate profitability goals are achieved.  Often this rate is referred to as the “hurdle rate”.   What is rarely discussed, however, is how to derive the appropriate discount rate on negative cash flows.

This issue comes up when valuing portfolios of distressed mortgage loans that are expected to throw off significant losses.  It is easy to construct such a portfolio where the NPV of the expected cash flows increases as the hurdle rate goes up.  This is counter-intuitive and does not reflect market reality.

A simple illustration may make my point:

  1. I have a contract to receive $100,000 one year from now.  I want to sell this receivable to you today.  You will pay me $91,000 if you want to earn 10% on your money (the hurdle rate).  If I were to tell you, however, that it is uncertain if you will receive the entire $100,000 a year from now, you will probably conclude that such uncertainty will demand a higher return – say 20%.  Accordingly, you will only pay $83,000 for the receivable.  Alternatively,
  2. I have a contract to pay $100,000 one year from now. I want to sell this payable to you today (i.e. give you cash to take over the liability).  Would you accept $91,000 from me if your hurdle rate is 10%?  If I were to tell you that the $100,000 is uncertain and you may have to pay more than the $100,000 a year from now, would you then accept only $83,000 for the payable?

Needless to say, #2 does not make any sense.  You would not discount the payable to this extent unless you were sure you could reinvest these dollars at 10%.  Not only is this implausible, but why would you want to share this upside with the seller?  You would probably use a risk-free rate such as the 1 month Treasury (0.02%).  If the payable amount is uncertain, and could be higher, you would certainly NOT discount the amount you want from the seller of this negative cash flow.  You would want an amount closer to, or equal to, the payable. 

On negative cash flows, you should not use your hurdle rate, but rather your marginal reinvestment rate, adjusted downwards for increased volatility.

The difference is huge.  The net present value of a constant negative cash flow of $10,000 per month for 15 years is $1.2MM at a 6% discount rate.  At a zero % discount rate it equals $1.8MM.  If $1.8MM reflects par (100), the $1.2 equals 66.  The former negative value (i.e. par) is more reasonable theoretically, and certainly more in line with the way the market looks at negative cash flows.



In the eye of the storm: Secondary Market Summary
April 27, 2009, 5:38 pm
Filed under: Lessons Learned | Tags: , ,

Editor’s Note: Frank Poiesz, President of Level 1 Loans, our valuation modeling group, attended the Mortgage Banker’s Association Secondary Marketing Conference in Chicago last week. The following is his summarization based on the general sessions, breakout sessions, conversations with presenters and discussions with attendees of The Mortgage Bankers Association Secondary Marketing conference. TJH

Ten Observations

Mortgage banking conference reflects industry
The Mortgage Bankers Association Secondary Marketing conference in Chicago was a shadow of its former self – attendance was around 700, and there were only 37 exhibitors, compared with several thousand attendees and more than 100 exhibitors in a more typical year. This may seem as expected given the times, but it was palpable, even shocking, to those attending. The difference was a constant reminder of the state of the economy and more directly of the state of the mortgage industry.

As with most industries, conferences directly reflect the health of the market and the outlook of its participants.

TARP and liquidity measure are ineffective
The government programs aimed at restoring liquidity (TARP, TALF and PPIP) have been slow to start and to date largely ineffective. Complexity, political concerns and lack of clarity about some of the structures have kept participants away. Despite protestations from panelists, absent substantial change – either in the programs or the perspectives of their target ‘markets’, they may have marginal long term benefit.

The lens of some observers may be colored by their benefit from TARP and other spending and therefore lead to a more optimistic view. Current lack of liquidity is an indication of ineffectiveness and without an exogenous event or other impetus to invest, participants may be sidelined for an inordinate amount of time.

The bottom has not been reached
Despite some signs of a bottom, speakers from the rating agencies and others signaled that home prices are likely still 10-20% away from stabilizing. Imbalance in supply and ongoing price drops in many markets is an indicator that there is additional downward pressure on real estate values.

Private investment still sidelined
Of strategic concern is the lack of private investment in the mortgage market; none of the speakers considered abatement of this concern in the short run to be likely. The combination of credit, collateral and systemic risks remains daunting (see the items that follow), so one can hardly blame investors. Risk premiums are likely to be significant if private capital is to be lured back to the party. Higher mortgage rates, possibly much higher, are the probable result.

Compounding this effect is the fact that many institutions are working on remediation of their existing portfolios and have stated an aversion to adding other investment vehicles during the course of 2009.

Liquidity gaps in non-conforming loans and warehouse financing
Two huge gaps exist today and no participant suggested they will close soon. The market for non-conforming loans (jumbo beyond conforming/jumbo, and any form of non-prime) is nonexistent. The only players for the foreseeable future may be those banks who provide portfolio loans to well-known customers. The second gap was a huge worry to participants at the conference – warehouse financing is difficult to obtain, leaving most non-depository lenders severely constrained. Even with Wells’ announcement of a new operation, and GMAC’s continued interest in adding customers (albeit with a 40% capture requirement), the warehouse lending market can be reasonably characterized as in crisis.

GSEs absorbing virtually all production via printing money
Speakers asserted that Fannie, Freddie and Ginnie are taking about 99% of current production. Further, it was asserted that most of this production is being funded by Treasury (printing money vs. selling bonds). The question is how to transition to a normal market – if treasury tries to liquidate its mortgage holdings, it will surely drive rates up significantly, though higher rates are a likely consequence of current policy in any event. A corollary – one can easily be skeptical that the current rates include any semblance of the proper risk premium. In fact, if one believes that real estate values have not bottomed, then the current rates are irresponsible.
Implication:

wider credit spreads, magnified by inflation and government debt-induced increases
= much higher rates
= drag on real estate values

This is an interesting repeat of the risk-ignorant behaviors (especially at FHA) that are being cited as causing this crisis.

Eventual form of GSEs unclear
Reorganization of the GSEs being inevitable, speculation about what form would emerge to replace them was common, and all over the board. The range of options included a replacement government agency, privatization resulting in a re-born Fannie/Freddie-like entity, and creation of an FHA-like government guarantor for loans of all types but absent portfolio capabilities. Until this comes clear it will be difficult to justify private investment in infrastructure to support a new MBS market.

Trust as a barrier to re-entry to private investment
Lack of trust in the market’s basic structure is a significant barrier to re-entry of private investment. All the participants are considered culpable here – originators, servicers, rating agencies, MI companies, issuers and government. There was no confidence that regulation or government leadership would solve this soon. Since industry leadership is sidelined by its current lack of credibility, the government is unlikely to arrive at a suitable solution, at least on first try.

Some of the suggestions, such as requiring originators to hold an interest in the loans they sell, are certain to crush non-depository lenders, if not the banks. Hopefully much of the current talk is political bluster. Nevertheless, it would be far better if a consensus about reform emerges soon.
With the U.S. government emerging as a more central actor in the market, decisions could possibly be politicized, influenced by a social agenda rather that a free market focus or otherwise based on imperfect advice.

Manual processing to restore trust
The trust issues have some of their roots in underwriting standards and processing shortcuts that were engineered to increase processing efficiency. This may have long-term implications for the evolution of automated decision technologies, and could result in an indefinite return to traditional manual processing and underwriting, driving up cost (yet another contributor to higher rates).

Path to MBS market reform is unclear
Reform of the ABS/MBS market is judged necessary if private investment is to return, but there is no consensus about how to achieve this. Rating agencies were subject to scorn, but there is no clear way put forth on to make their motives (their revenue) match investor risk concerns. Some postulate that MBS ratings will be ignored in favor of investors having their own risk assessment capabilities, but how this would be achieved is unclear as well. Certainly, community banks can’t assess structured debt risks as well as a large private equity fund or global bank. Does that mean that small banks are out of the game except as whole loan investors to customers they know?

Conclusion
Many participants reinforced the belief that US Treasury Debt-related inflationary pressures coupled with the higher rates required to attract private investment would act to further slow the real estate market in 2010 and beyond. This seems inevitable unless the administration changes course significantly, accepting a slower recovery by tightening credit carefully.

The current market for mortgages is in a significant respect artificial – one cannot reasonably characterize the US Government as a ‘willing buyer’ in a free market. The Treasury’s political agenda (to support housing and therefore the economy) is enough to justify this position. True recovery and a return to a free market requires the Treasury to be replaced (as the mortgage funding source), at least in large part by private investment. Bank portfolios will be the first to return (in my opinion), but cannot absorb enough volume to cement the recovery. Until a vibrant MBS market returns, and until the US government is not the only source of credit for housing, there will be a cloud over the US Real Estate market. Given this outlook and the likely long duration of mortgages at today’s price levels, portfolios are well advised to invest in loans with care –the Treasury-guaranteed bonds are a better option until spreads more accurately reflect risk.

All this uncertainty makes it difficult for those responsible for strategy anywhere in the industry. The market flexibility of the past 10 years will not return any time soon. The only certainty is that shops need to be nimble in responding to changes in an increasing portfolio of government programs – loan servicing operations in particular will face significant stress in this regard.

This pessimism notwithstanding, there will be opportunities for companies able to respond appropriately. In fact, there is huge potential among small to medium size banks which could, with proper strategic guidance and diligent execution, seize the opportunity to achieve dramatic returns with a reasonable level of risk.