Valuing Mortgage Servicing Rights: What You Need To Know

Mortgage Servicing Rights (MSR) is an arrangement where a third party collects mortgage payments on behalf of a lender in exchange for a fee. MSRs are a modified interest-only strip, with the expected life of the loan calculated based on its expected prepayment rate. The servicing fee is paid monthly, based on the outstanding principal balance of the loan and can vary by type of investor. Mortgage servicing rights also include billing the borrower, collecting and disbursing taxes and insurance premiums, accounting for these activities, and forwarding funds to an investor in the secondary market. The valuation of MSRs is impacted by changes in interest rates and the expected cash flows related to servicing activities.

How do you value mortgage servicing rights?

The role of third-party companies in collecting mortgage payments

Mortgage servicing rights (MSR) are a specific arrangement where a third party collects mortgage payments on behalf of a lender in exchange for a fee. This is done through a contractual agreement. The third-party servicing company can earn a profit without bearing any risk of owning mortgage loans. They simply specialize in the collection of payments and other mortgage servicing activities. Mortgage servicing rights represent a significant revenue source for many independent mortgage banking companies and community banks.

Mortgage servicing rights come into play when an original mortgage lender sells the rights to service a mortgage to another party. Mortgage lenders often take part in this process because it saves money and time. Lenders can then spend more time originating loans to other potential homeowners. Third-party mortgage servicers handle the day-to-day tasks involved with mortgages, such as collecting monthly payments, managing mortgage insurance fees, allocating principal and interest in mortgage payments, and managing property taxes.

Many mortgage servicers engage external third-party appraisers to provide estimates of the fair value of their mortgage servicing rights. Estimated future net servicing income includes estimated future cash inflows and outflows related to servicing. Estimates of cash inflows or servicing revenues should include servicing fees and other ancillary revenue, including float and late charges. Estimates of cash outflows or servicing costs should include direct costs associated with performing the servicing function and appropriate allocations of other costs.

Mortgage servicing rights create a natural hedge or protection on the supply side of the mortgage lending business. When interest rates rise, there are fewer prepayments, and the value of mortgage servicing rights increases. However, when interest rates are low, the prepayment speed increases, and the value of mortgage servicing rights decreases. Prepayments are when a borrower decides to pay back more than the required principal according to a loan agreement.

The impact of interest rates on the value of MSRs

Mortgage Servicing Rights (MSR) refer to a contractual agreement that gives the right to service an already-existing mortgage. MSRs represent the financial interest in the servicing fees and related income generated from managing a mortgage loan, which can be retained by the lender or sold to investors in the secondary market. MSRs are actively traded in the secondary market among financial institutions, investors, and specialty servicing firms seeking to optimize their portfolio returns and mitigate risks.

However, MSRs exhibit a unique behaviour compared to other asset classes. Typically, when interest rates rise, the value of MSRs also increases. This is because higher interest rates can decrease prepayment rates, meaning borrowers are less likely to pay off their mortgages faster. This results in longer repayment periods, which benefits the servicing firm as they can generate more income over time. Additionally, higher interest rates can increase earnings from principal paydowns, payoffs, and escrow accounts, boosting MSR values.

On the other hand, higher interest rates can also negatively impact MSR values. When borrowers struggle to keep up with mortgage payments, servicing firms must advance principal and interest payments to investors, along with insurance and property tax disbursements. These higher interest rates lead to increased advancement costs for servicers. Furthermore, higher interest rates can contribute to economic recessions, increasing the risk of defaults or delinquencies, which adversely affects MSR values.

It is worth noting that the impact of interest rates on MSR values is not isolated from other factors. The performance of the underlying loans, servicing fees, loan origination practices, regulatory conditions, and market conditions all play a role in shaping the value of MSRs. Therefore, while interest rates are a significant driver, they are part of a broader set of considerations when valuing MSRs.

The calculation of the servicing fee

Mortgage servicing rights (MSR) refer to the right to service a loan on behalf of an investor and collect a servicing fee. The servicing fee is paid to the mortgage servicer as compensation for their services, which include keeping a record of payments, collecting and making escrow payments, and passing principal and interest payments to the note holder.

It is important to note that the servicing fee is just one of several fees associated with a mortgage loan. Other fees may include application, underwriting, title search, and appraisal fees. Additionally, there may be closing costs, which are due when the loan is closed and can range from 3% to 4% of the home's price. These costs can include property taxes, homeowners' insurance, and other fees.

The servicing fee is an important attribute of the loan, and changes in interest rates can impact the value of MSRs. The expected life of the loan, which is calculated based on its expected prepayment rate, is a key valuation variable. The fee is also influenced by the type of investor, with standard fees varying for fixed-rate conventional, conventional ARM, and Ginnie Mae loans.

To determine the fair value of mortgage servicing rights, independent servicing brokers, peer and industry group surveys, and external third-party appraisers may be consulted. This valuation considers estimated future cash inflows and outflows related to servicing, including servicing fees, late charges, direct costs, and other ancillary revenue and costs.

The recognition and measurement of servicing rights

Servicing rights are most often associated with assets such as mortgage loans, credit card receivables, automobile loans, and trade receivables. The contractual right to service these financial assets can be developed or acquired through a contract or the origination of a financial asset.

ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In many situations, the assumptions that market participants would use in computing the fair value of servicing rights are not available due to a limited number of market participants, imperfect information, or other conditions. In such cases, companies will likely need to estimate expected cash flows related to servicing activities using their own historical cash flow experience as a basis for formulating assumptions.

The fair value of the servicing assets or liabilities should represent the difference between the benefits of servicing and adequate compensation. The initial measure for servicing may be zero if the benefits of servicing are just adequate to compensate the servicer for its responsibilities. If quoted prices are not available, the estimate of fair value should be based on the best information available, given the circumstances.

Estimated future net servicing income includes estimated future cash inflows and outflows related to servicing. Estimates of cash inflows or servicing revenues should include servicing fees and other ancillary revenue, including float and late charges. Estimates of cash outflows or servicing costs should include direct costs associated with performing the servicing function and appropriate allocations of other costs. Estimated future servicing costs should be determined on a market value basis.

The benefits of servicing versus compensation

Mortgage servicing rights are typically derived when a lender originates a residential mortgage loan and sells it to investors on the secondary market while retaining the servicing rights. The secondary mortgage market helps reduce the risks associated with owning a mortgage. The market for MSRs is usually strong during periods of economic growth, due to higher-quality mortgage originations and lower default rates. This makes MSRs attractive to hedge funds, banks, and real estate investment trusts (REITs) as they can yield high amounts of interest.

Mortgage servicing rights can also be sold to a third-party company, which then takes over the responsibility of collecting payments and ensuring the loan is repaid. This can be beneficial for lenders as it allows them to outsource time-consuming and costly tasks, leading to better resource allocation. Additionally, third-party lenders can collect fees with little risk involved. The fair value of servicing assets or liabilities should represent the difference between the benefits of servicing and adequate compensation. This value is often estimated by external third-party appraisers and is based on expected cash flows related to servicing activities.

Mortgage servicing rights also have benefits for borrowers. When MSRs are sold to a third party, the borrower's mortgage payment amount, interest rate, type of loan, and other factors remain the same. The only significant change is that the borrower sends their payments to the new servicer. This can provide borrowers with a more efficient and specialised service, as the third-party company focuses solely on servicing the loan. Overall, the benefits of servicing versus compensation in mortgage servicing rights create value for both lenders and borrowers, contributing to a more dynamic mortgage market.

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