A Primer on Hedging Servicing
STRATMOR has seen that the pace of blocks of servicing being sold and bought, large and small, has increased dramatically, and should continue through the end of 2021 and potentially beyond. “Why?” Smaller companies, which added servicing last year because aggregators weren’t paying for it, now want to re-deploy cash to try to outlast their competitors with declining or leveling off margins and volumes. Versus when mortgage rates were lower and didn’t have a lot of direction to go other than up, now there’s not as much agreement on the direction of rates. And that helps make a market.
For those companies who opt to retain their servicing, protecting the value of the servicing is very important. Like commodity prices, or a locked mortgage pipeline, the value of MSRs can be hedged. Let’s begin this primer with a discussion of what servicing is, why servicing has value, what a servicer or lender is protecting, and the basics of how to hedge its value and quantity.
The primary source of servicing cash flows is from the strip of interest from the loan earned by the servicer and based on the accounting rules becomes an MSR asset when a mortgage loan is sold servicing retained. Mortgage servicers are responsible for the collection of payments on the mortgage loan and the distribution of these payments to the appropriate authority (including investors, tax authorities and insurance companies).
The strip of interest is paid to the servicer to perform the servicing duties based on the investor guidelines. This contractual minimum service fee is primarily 25 basis points for conventional conforming (Freddie and Fannie) servicing, 44 basis points for Ginnie Mae I servicing, and varies from 19 to 69 basis points for Ginnie II servicing. The servicing value is expressed as either a multiple of the service fee or as a percentage of the unpaid principal balance (UPB). For example, a FNMA loan that has 25 bps of interest’s value can be expressed as a 4 multiple or 100 bps.
Servicing is a numbers game. Simply put, if it costs a servicer $10 a month to service a loan and the servicer is paid $50 a month to do so, it is a source of revenue. The longer that situation exists, and the loan is “on the books,” the better. Originating or buying servicing and valuing it as if you’ll own it for years, only to have it pay off (prepaying) in four months, is a money-losing situation. The value of servicing is the net present value of the servicing revenue components, less expenses, adjusted for prepayment speeds. So, if expenses increase, or the income decreases, it is a problem.
While the majority of the cash flows and therefore value of the MSR asset is driven primarily by the strip of interest, the servicer also can earn income from late fees, ancillary income, and float income. Put another way, on the income side, MSR valuation is composed of service fee revenue, escrow float earnings, principal and interest (P&I), and payoff float earnings, ancillary income (late fees, modification income, optional insurance, etc.). On the expense side, there are servicing costs, additional costs for delinquent loans and foreclosures, advances on delinquent P&I and escrow payments, interest owed on escrow accounts in some states, interest owed on early payoffs (unique to scheduled / scheduled products), prepayments, voluntary payoffs through refinances, and involuntary payoffs through foreclosures.
Understanding the servicing experience of the customer is critical. STRATMOR clients know that prepayment speeds are the key driver behind servicing values: The longer a performing MSR is held in the portfolio, the more revenue will be received. And as interest rates rise, prepayment speeds will slow down, increasing the duration and resulting value of the MSR. And as interest rates drop, prepayment speeds will rise, which will decrease the life and the value of the MSR.
There are risks to holding and owning MSRs that are often hedged. Refinancing removes the cashflow and possibly the customer relationship. The borrower is “long” an option: they have the ability to end the relationship that the servicer does not through exercising the prepayment option by refinancing into a lower rate. This is the source of the negative duration and negative convexity of the MSR value profile. As rates rise, voluntary speeds slow and the cash flows extend, increasing values, and as rates fall, voluntary speeds increase and the cash flows shorten, decreasing values.
So how do servicers and lenders offset the potential losses (or gains, given the strict definition of hedging) that may be incurred? The general approach to hedging MSRs starts with looking at the key attributes of servicing: MSRs lose value as rates fall due to the increase in prepayments, creating “short” duration. The sensitivity is to changes in mortgage rates, which in turn are usually modeled as a spread over the U.S. risk-free 10-year Treasury note. This can be hedged using an instrument that is “long” duration, like 10-year Treasury futures or 10-year swaps. It is important to be aware of “second order” risks such as convexity risk and basis risk but attempts to hedge them can be costly and create complexity and profit and loss (P&L) volatility. Usually, a “long duration” position has positive carry due to an upward sloping yield curve, which can create a cushion to absorb second order risks.
Prepayment speeds are impacted by other factors besides interest rates. These include product (ARM versus fixed), term (30- versus 15-year), home prices, government programs (such as HARP), seasoning, loan-to-value (LTV), and government intervention with foreclosures.
Any servicer should do a thorough analysis of hedge policy considerations. These include risk appetite, approved hedge instruments, trading authorities, and limits on positions. Hedge instrument considerations include the instrument’s duration and delta (change) in different interest rate environments, convexity, volatility, time decay, liquidity, cost of carry, margin requirements by investment banks. All instruments have some type of basis risk which encompass Treasury rates, swap spreads, and MBS primary/secondary spreads.
Lenders hedging their locked loan pipelines use TBAs (“to be announced” securities, or generic mortgage-backed securities not containing specific loans). Those lenders are “long” the loans in their pipelines, and therefore want to be “short” securities backed by mortgages. Whether used for loans in process or for being long a servicing portfolio, these securities are highly liquid and have a strong rate correlation, but often have a poor convexity match. And, there are margin considerations during a market move.
Third party servicing hedging vendors often use swaps/futures, typically based on U.S. Treasuries, which can be matched duration-wise. But there are basis exposure and margin requirements. Options, primarily puts and calls on U.S. Treasuries can be used, but there are issues with basis: Treasury rates don’t always move the same way as U.S. Treasuries.
Some servicers and lenders, rather than hiring a third-party vendor to hedge servicing, use “recapture” as a simple / production hedge. This involves a direct-to-consumer (DTC) department to call on the borrowers in our servicing portfolio before competitors can refinance them. Lenders, however, have had operational capability issues, compliance concerns, and accounting nuances that can create problems. But with rates having ratcheted after this summer, the overhead of a team dedicated strictly to refinancing is difficult for some companies to swallow, despite many of the teams moving toward purchase business.
And still other companies view, from a company-wide perspective, total income and balance sheet fluctuations in a holistic manner. “Sure, rates have gone up, and volume has dropped off, but our servicing is worth much more.” And when rates go down, “Well, servicing is running off and the value has dropped but we’ve picked up volume.” A careful analysis, however, will tell you that this is imperfect at best, and at worst can mask deficiencies within the company from a cash flow and overhead perspective.
Through workshops and peer group data gathering, STRATMOR has found that not everyone hedges MSRs for a variety of reasons. “Exchange-traded contracts or OTC derivatives are too expensive due to margin requirements.” While this does create cash demands, it is not a cost that goes through P&L. With careful management, net positive income over the long term can be achieved while offsetting most of the market risk in the short term. Some management teams believe that hedging servicing is too complicated and doesn’t work. But a disciplined, repetitive approach in evaluating the risk on the servicing portfolio can overcome this. The hedge objective must be defined, risk tolerances established, and operating procedures implemented.
We tell our clients that the MSR asset is volatile and can be just as volatile as the MBS market. Understanding the actual cash flow is critical. An effective risk management process is critical to understanding and managing the risks of both an unhedged and a hedged portfolio. Effective risk management is an on-going process that requires continual monitoring, improvement, and regular reporting and communication. Whether or not the servicing portfolio is hedged, going through the exercise of evaluating the risk and making a hedging decision is something every company should do.