KBRA: Mortgage Security Risks and Diminishing Investor Confidence

House on Money BHKroll Bond Rating Agency (KBRA) recently released a research reportentitled “Mortgage Servicing Rights: Catching the Falling Knife” discussing mortgage security risks (MSR) and investor confidence.

In May of 2016, KBRA noted that continued writedowns of MSRs has in their opinion diminished investor confidence in a number of non-bank mortgage firms. This negative impact of MSR adjustments has also taken a toll on the earnings of depositories according to the report, and gives another negative factor for investors to take into consideration with bank financial results.

The report states that since September of 2008, when the fair value (FV) of MSRs held by US banks peaked over $80 billion, the value of the payment intangibles has reduced to currently be $36 billion. KBRA says that even allowing for write-downs, purchases, and sales of legacy MSRs by commercial banks over that period, the FV of the aggregate MSRs has decreased by half over the past seven years. Likewise, the report notes that this decrease reflects the dramatic change in sentiment on the part of investors in regards to to this asset class.

KBRA believes, however, that you cannot blame FV accounting for the market volatility caused by Fed monetary policy. Instead they attribute the volatility seen in the market for MSRs to being another example of the downside of market manipulation by the Federal Open Market Committee (FOMC). They share that at the peak of “quantitative easing” by the FOMC, MSRs were trading to the tune of four times cash flow.

According to the report, investors were drawn to distressed mortgages as an asset class because of the possibility of large returns from resolving delinquent loans. However, they note that these new investors learned that apparent front-end returns for a distressed mortgage portfolio typically fall away as the more attractive assets are resolved. KBRA reports that while MSRs were once trading at 4-5 times annual net servicing revenue, starting in early 2015, MSRs holders began to see a deterioration of market prices and liquidity. They say that this is in part because the continued low interest rate environment and stable prepayment rates, but it is also because of the erosion in servicer profitability when the compliance costs rose.

The report shares that a major issue some investors have expressed to them over the past year is the MSRs sellers’ practice of immediately soliciting the underlying borrowers for mortgage refinancings in pools they’ve just sold to investors. KBRA cites that these practices violate standard industry terms and don’t help contribute to investor confidence especially with prepayment rates already at high levels.

Additionally, KBRA says liquidity in the market for MSRs is rapidly disappearing due to falling interest rates and the negative impact of adjustments in the FV of MSRs on the earning of banks and non-banks alike. They say that added cost due to regulation both for the loan origination and servicing businesses has seemingly lowered enthusiasm for what they call naturally occurring negative duration asset.

KBRA believes that regulators and policy makers need to take notice of the dwindling liquidity in the MSR market and consider what it says about the economic model for loan servicing.  They say that market liquidity for bulk sales of FHA and VA loans has largely diminished as commercial banks and institutional investors have exited the Ginnie Mae market.

In regards for what KBRA expects for the future, they say that as Q3 2016 earnings reports for banks and non-banks approach, they expect to see continued downward pressure on earnings for banks and non-banks due to adjustments to MSRs. Additionally, the trend in terms of interest rates, prepayments and other factors that affect estimated valuations for MSRs is something that KBRA feels indicates revenue multiples are likely to decrease for the rest of 2016.  In terms of liquidity, KBRA believes that investors and regulators need to also consider the number of bulk MSR sales that have not taken place in 2016 due to the lack of investor demand.

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