The Emperor's New Clothes


May 15, 2012 Prepay Speeds

Mid-month SIFMA prepay speeds have been uploaded to the L1 Analytics valuation model.  As can be seen below, these PSA speeds have increased from last month-end.  This is not a surprise.

The Freddie Mac primary mortgage market survey shows the 30 year fixed mortgage at 3.83% as of May 10th. In concert with HARP2 and the mortgage servicer settlements, the MBA application index is up 1.7% for the week ended 5/4.



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.



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.



MSR 3rd Quarter 2011 values

As anticipated, MSR prices, as of September 2011 10Qs, are down once again.
 



Mortgage Rates – week ending 5/13/10
May 13, 2010, 12:58 pm
Filed under: Mortgage Rates | Tags: , ,

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.



Mortgage Rates – week ending 5/7/2010

Correspondent par mortgage rates dropped 9 basis points over the last week ending at 4.67%; the spread over the 10 yr treasury increased from 100bp to 126bps.  The spread to the Freddie Mac primary market survey rate of 5.00% increased from 30 to 33 basis points.

The  jumbo market seemed to have lost some of the euphoria from Redwood Trust’s successful private-label jumbo securitization.  Spreads to comparable conforming product increased from 174 to 207 basis points; a still relatively attractive spread.

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.



Mortgage Rates – week ending 4/30/10
April 30, 2010, 4:40 pm
Filed under: Mortgage Rates | Tags: , , ,

Correspondent par mortgage rates changed little over the last week ending at 4.76%; representing a 100bp spread over the 10yr treasury.  This is approximately 30 basis points under the Freddie Mac primary market survey rate of 5.06%. 

Of more interest is in the jumbo market.  5.0% 30 year jumbos had been trading 248bps under comparable conforming loans as of 4/23.  That spread has come down to 174bps.  It will be interesting to see where this goes next week.

NB.  For daily pricing on a more diverse set of loan programs please visit Level 1 Loans Index.