A Mortgage Servicing Right (MSR) is the contractual right to perform loan servicing functions for an underlying mortgage. The servicer is responsible for carrying out defined activities that are prescribed in the mortgage document, such as collecting principal and interest payments from the borrower, remitting those payments to the lender and generating reporting for all interested parties (from the mortgagee to government regulators).
Birth of MSR
Traditionally, mortgage lenders serviced their loans “in-house.” However, after the Great Depression, the United States’ government created multiple federal institutions to encourage home ownership, from the Federal Housing Administration (FHA) to the Federal National Mortgage Association (FNMA).
During the latter half of the twentieth-century, these entities began selling interests in mortgages that they owned (called “participation certificates”), which ultimately led to the secondary market in mortgage-backed securities (MBS). The market for MBS was then fueled by the creation of the Real Estate Mortgage Investment Conduit and the Financial Institution Reform, Recovery and Enforcement Act of 1989.
To facilitate the sale of mortgages between entities (including special trusts that enable the formation of MBS), the contracts were written in a fashion that specifically called out the loan servicing functions. In this way, loan servicing functions could be pooled and performed by specialized mortgage-servicing institutions (including most of the nation’s major banks), while the underlying mortgage could be sold (either as whole loans or as MBS) to third-party investors (such as insurance companies and pension funds). As compensation for performing these servicing functions, mortgage servicers are paid a fee (usually between 5 and 50 basis points) out of the monthly interest payments.
If a mortgage is structured in this way (virtually all modern mortgage are), a mortgage lender can originate a loan, then sell each component either individually or in concert. This often gives rise to great confusion from the borrower’s perspective, most of whom are used to their normal banking relationships in which they get to select the institution they would like to do business with and they maintain that relationship at their discretion.
With mortgages, borrowers may receive multiple notifications that their loan or their servicing has been sold from institution to institution. They are no longer in control of the relationship, and to make matters worse, hand-offs between servicing institutions are often not seamless. Payments are lost, statements are not sent and other errors occur that can affect the borrowers and add to the confusion.
How Mortgage Servicing Rights Work
Servicers are paid a monthly fee to perform their duties, which largely involve collecting money from borrowers, remitting it to the mortgage owners (or bond owners in the case of trust-owned MBS), generating reports and otherwise maximizing the return on the mortgage. With scale and the appropriate systems and processes in place, mortgage servicing can be an incredibly profitable business. In fact, is a multi-billion dollar industry in the U.S. alone.
In addition to earning servicing income from the servicing activities, since mortgage servicers are in contact with mortgage consumers (i.e. homeowners), the servicers are in a prime position to market other financial products to those borrowers. These products can create additional income for the servicing institutions.
Mortgage Servicing Rights Valuation
From a servicing institution perspective (or an investor’s perspective in that servicing institution), MSR represent assets to the servicing institution. They are the contractual rights to a future stream of cash flows (net of the cost of performing the obligation). While the accounting rules are complicated, the basic principal is that MSR should be reflected as an asset on the balance sheet at its fair market value (essentially the present value of the expected future revenue less the cost to earn that revenue).
While that seems straightforward enough, the complicating fact is predicting the length of the revenue stream. While mortgages are generally 30-year instruments, the average life of a mortgage is only 5-years, depending on market factors. As interest rates fall, people tend to refinance, which means that the term of the MSR shortens and the opposite is the case for an increasing interest rate environment.
Also factoring in to the equation are the interest that can be earned on monies in escrow, late payments that can be collected, etc. Therefore, complicated financial models are required for mortgage servicing rights valuation (and to hedge against its decline) and no two institutions value them entirely the same.
MSR Controversial Practices
During the housing boom, servicers collected large portfolios of MSR. With home prices on the rise and unemployment low, borrowers were largely making timely payments. If they weren’t able to, the increasing home values enabled them to pay off or refinance their mortgage. Servicers became experts at collecting monthly principal and interest payments and processing mortgage pay-offs. They were able to handle the volume, generate a profit and adequately service the loans.
As the housing market busted, home price deflation prevented borrowers from selling or refinancing their mortgages, sending delinquencies dramatically higher. Unemployment increased, contributing to the problem and further reducing demand for homes as well as increasing the number of foreclosures. Mortgage servicers were quickly overwhelmed by the massive shift in borrower behavior and contractual terms were often ignored or required practices not followed (such as notification before foreclosure). To keep up with the volume, some servicers foreclosed on properties without proper documentation or by following the legal requirements.
In addition, most servicing arrangements allow the mortgage servicer to collect fees for delinquencies, which encouraged servicers to delay payment processing and engage in other nefarious practices. Some were conscientious, some were accidental — all hurt consumers.
Adding even more fuel to the fire, since the servicers did not necessarily own the underlying mortgage their ability to flexibly work with borrowers was limited to what was contractually allowed in the mortgage agreement, which in many cases was very little beyond foreclosure.
Consumer Finance Protection Bureau
In April 2012, the Consumer Finance Protection Bureau (CFPB) announced proposed changes to the rules surrounding mortgage servicing. The CFPB’s rules are an attempt to address the most egregious and common of the issues with mortgage servicing. As with the other corrective actions taken by government institutions, it remains to be seen whether this will solve the problem.
In addition to his other activities, Chad Fisher blogs for the team at http://www.personalhomeloanmortgages.com/, who believe that educated consumers make for a healthier economy.