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A pivotal year for servicing.

Buyers of servicing were out in droves this year looking for newly minted, low-coupon production. But a shortage of sellers, of this very desirable new servicing, sent prices on a rally. The question is how long will any of this last?

Interest rates have fallen fairly steadily in 1992, bringing a rush of refinancing activity and rewarding lenders who maintain efficient loan origination capabilities. However, servicing managers tend to have a more complex outlook on the effects of this year's record originations. They recognize that every refinanced loan represents a prepayment in a servicing portfolio.

What occurred this year has even greater ramifications for servicers than net gains or losses in the size of their portfolios. Data from Fannie Mae and Freddie Mac help explain what happened in servicing portfolios during the first half of the year. Refinance business for Fannie Mae nearly doubled from the last half of 1991 to the first six months of 1992, reaching a high of just in excess of 50 percent of all the agency's transactions.

Portfolios experienced a marked change in product mix as a result of the refinancings. In the first quarter of this year, 43 percent of borrowers holding 30-year loans that were refinanced, and then sold to Freddie Mac, had moved into 15-year mortgages.

More than 80 percent of the 15-year loans that refinanced stayed at that maturity, while only 12 percent of ARM refinancings continued on as variable-rate loans. The vast majority of adjustable loans that refinanced in 1992 became fixed-rate mortgages, with 15-year loans the fastest-growing product.

Lenders have little control over consumers' product preferences. When mortgage rates rose above 15 percent a decade ago, a fixed-rate loan was hard to sell. But today, many homeowners are convinced that lower rates are unlikely and want to lock in their loan payment at current levels. Servicers, in general, can be pleased with this new production, which amounts to financing stable homeowners who have equity in their properties and a proven ability to make payments--even at a higher interest rate.

Today's bulk market

Recently, buyers have outnumbered sellers in the bulk servicing marketplace. It's not surprising that servicers want to secure as much of today's production as they can. Interest rates are at lows few would have dreamed of just a few years ago and current production should have greater resistance to refinancing than the double-digit, fixed-rate loans originated in the 1980s.

Four main reasons are keeping supply low and demand high for quality servicing:

* The attractiveness of current production, in terms of its low potential for future refinancing activity, makes it difficult for servicers to elect to put it on the market. Seasoned servicing--which might be offered instead--is selling at a large discount today. This is a result of anticipated high prepayments, and concerns that prepayments could ultimately exceed even current expectations. Yet, because seasoned portfolios have already experienced runoff from this year's refinancings, owners are reluctant to accept a further discount on prices now. They recognize that if rates increase in the future, bid prices for seasoned packages could also rise, reflecting lessened prepayment concerns.

* Lower short-term rates have reduced the cost-of-funds at many financial institutions. Yet, as a result of the steep yield curve and the time lag required for adjustable-rate mortgages to adjust down to current interest-rate levels, earnings are up at many banks and thrifts. Better profits mean there is less need to sell servicing in order to satisfy shareholders, increase capital levels, or invest in new offices or technology for future business growth.

* Resolution Trust Corporation (RTC) sales have diminished this year, because Congress has not appropriated enough funds for the RTC to bring large amounts of new servicing from failed thrifts to the market.

* Finally, some mortgage firms that traditionally sold servicing to fund their operations have issued stock in the last year. Now, with millions in capital, they are turning from being bulk sellers to holders and/or buyers of servicing packages.

Today's prices

New production of conventional, non-recourse, agency servicing is priced higher than it has been since the mid-1980s. Packages of 30-year loans with escrows now are seeing prices at 5.5 times their annual servicing premiums. Fifteen-year mortgage portfolios are receiving bids of four and one-half times their premiums, and servicing on seven-year balloon mortgages is selling at four times the annual servicing fee.

GNMA servicing prices have not risen to the same extent, because there is less demand for these packages. Some servicers are concerned about having to make annual assessments of FHA mortgage insurance premiums and the possibility of increased lender exposure resulting from a change in the Veterans Administration's accounting policy on no-bids. Consequently, more originators are putting less emphasis on government loans today than in the past. Reduced numbers of FHA originations also have encouraged some servicers to devote their resources to other products.

However, GNMA servicing transfers in the first half of 1992 still reached $20 billion--up slightly from 1991 totals. Total servicing transfer volume should drop below $150 billion this year, down slightly from 1991 levels.

Overall, the lack of product for sale has limited the market in 1992 and contributed to the rally in servicing prices. Unless an external factor prompts firms to put more packages on the market--such as unexpected marketing losses--servicing prices for current production should stay in today's ranges for the near future.

1993 activity outlook

More lenders now seem intent on building their servicing portfolios as long-term assets. But will this trend continue and cause prices to remain strong or perhaps rise even higher? One way to examine that question is by looking at the reasons given earlier for today's demand/supply imbalance and examining the prospects for those conditions changing.

Today's low rates make current production attractive to hold.

As long as the economy stays sluggish, interest rates should not rise appreciably. Long-term rates could, in fact, fall further, tempered primarily by the need to attract capital to fund the federal deficit and lingering concerns about a return to 1980 levels of inflation. Lower rates would translate into more home sales and refinancings, continuing the present trend in which recently produced product falls out of favor as more-attractive current servicing reaches the market.

However, most observers see greater chances of interest rates rising than falling, simply because today's mortgage rates are at their lowest level in about two decades. A rate increase would most likely make today's production more valuable, as its future prepayment risk drops. Higher rates also would mean fewer originations, which might induce some originators to access the bulk servicing market in order to fulfill their growth projections. To the extent that this scenario is anticipated, those future price increases would be partially impounded in today's bulk servicing market prices.

If rates stay the same, refinancings eventually will slow and origination volume will decline--unless the home purchase market picks up. In this case, lenders would need to find other ways of adding servicing to their portfolios in order to meet growth goals.

Many depository institutions and mortgage bankers have less need to sell servicing in order to boost earnings.

Some of this change is permanent. Lenders who have accessed the capital markets might rarely sell servicing in the future. But if rates rise, depository institutions could become sellers in order to boost earnings. However, this year's profits have helped many boost their capital, thus making future servicing sales less likely.

Higher interest rates would likely give smaller mortgage bankers incentives to sell servicing, however, in order to offset reduced fee income and higher per loan overhead costs as originations drop.

Fewer RTC packages are coming to market.

Next year, the RTC should have renewed funding and thus be able to bring more servicing packages to market.

So, although interest rates have the major impact on the value of servicing, other factors are at work that will also affect the price of servicing packages. Higher interest rates could mean greater demand for today's production, but that excess demand could partially be offset by increased servicing sales from smaller mortgage bankers and the RTC.

Profitable acquisitions

Rather than simply viewing certain price levels as attractive or unattractive, many servicers analyze the market in terms of their firm's capacity, product mix or geographic concentrations, and incremental servicing costs. If purchasing servicing rights is profitable at current prices, relative to the servicer's costs, capacity, and ability to produce something close to the expected return on these assets, then servicing buyers will enter that market for that product.

At times, a lender will act aggressively as a buyer in a product area where the servicer has familiarity. Taking calculated risks in a situation where the variables are well understood will put servicers more in control of their destiny. Some servicers, for instance, are bidding aggressively to win selected portfolios. Although 80 to 90 percent of all bids fall into a predictable range for any given portfolio, in 1992, often one or more bidders went to a higher level to increase their chance of winning the auction.

Some bidders take such a step because they have excess servicing capacity, making them eager to buy, and thus they resort to fine-tuning their bids after losing several auctions using their standard pricing assumptions. Others know the seller from a previous transaction and prefer to pay more for what they anticipate will be a trouble-free transfer. Servicers can make such strategic choices when they understand today's market and their company's expenses, strengths and weaknesses.

Trend or cycle?

A key for anyone in the mortgage business today is deciding if today's volume and interest-rate trends are cyclical, or whether or not conditions have altered for the long-term. Business planning involves choosing an overall approach, and requires having an idea of what the market will be like in the future. Mortgage lenders find this exceedingly difficult to do, because the business is affected largely by unpredictable interest rates.

Because it is so difficult to anticipate the future, many mortgage firms today position themselves to be able to quickly pursue a variety of strategies to meet corporate profitability goals.

No firm wants to change its strategy just because the business cycle shifts. Yet, no company can afford not to alter how it works when the forces driving the marketplace are rearranged. However, detecting the cyclical trend from the fundamental shift can be difficult and is often only recognized in hindsight.

For instance, firms that decided to pursue a servicing-only strategy a few years ago had compelling reasons at the time to do so. It was a period of relatively low origination volume, yet many lenders just had expanded their servicing facilities. Overcapacity, thus was a problem for some lenders. What's more, the interest rate spike, which ended the previous refinancing boom in the spring of 1987, had shown many lenders that secondary market losses are more than a possibility in times of volatile rates.

But now, just a few years later, lenders are enjoying falling rates, secondary market profits, a yield curve that is supplying positive warehouse spreads, and record origination figures. Today, firms that stayed in the origination business are generally doing very well, while servicing-only companies are having to increase their acquisitions or downsize due to excess servicing capacity created by this year's high prepayment rates.

Other sources

Bulk purchases are only one channel available to servicers seeking to build their portfolios. Servicing can be acquired through bulk, flow or assignment-of-trade purchases, as well as with correspondent, wholesale or retail originations. At times, the economics behind these various means of building a portfolio shift, and one will be favored over another for a period. Together, they can help ensure that a mortgage firm will avoid excess capacity and use its resources to acquire servicing effectively.

Some servicers today are buying production units in order to have a constant source of new loans. Bid prices for production units can generally be derived by determining the present value of income streams generated from future originations.

Other buyers have expressed an interest in flow purchases. Under these agreements, a buyer will commit to purchase a portion of a lender's production for six months to a year using a fixed-price formula. Sellers benefit by locking in a market and a price for their production; buyers appreciate knowing how many loans they'll be adding in the future, and what the cost for them will be.

Flow prices rose as interest rates trended down this year, because buyers perceived that future production would be at lower rates with less potential for early prepayments. Servicers today are paying as much as 2 points for government loans delivered on a flow basis.

Careful purchases

Servicing buyers are continuously adding to the sophistication of the market. Today's buyers analyze servicing packages using their own programs and spreadsheets, so that the portfolio can be modeled to their specifications before a bid is made.

More questions are being asked by servicing buyers. Some want to know what percentage of the loans came from third-party originators, such as mortgage brokers. Others focus on portfolio breakdowns by zip codes or counties, in order to avoid areas seen as having higher-than-average delinquencies or prepayments. When deciding what to buy, servicers often look at what product performs most profitably in their own portfolio and then try to find similar loans. Others seek to diversify their portfolios and reduce the risk generated by having high concentrations in particular geographic locations, product types and the like.

Still other servicers specialize in loans that are out of favor with the majority of lenders, due to their non-conventional characteristics or high delinquencies. A servicer who can buy a highly delinquent portfolio at a discount and then cut the delinquency rate by a third, will do well. For servicers, knowledge of their own capabilities and portfolios is as important as being aware of what's happening in the bulk sales marketplace.

Thirty-year, fixed-rate loans continue to have the most appeal to buyers, because their cash flows are the best-known. Some big purchasers won't bid on a package if it doesn't contain primarily conventional, conforming, 30-year product.

Servicing prices tend to be relative to a portfolio's size. In general, there are three pricing strata based on a portfolio's size: under $100 million, up to $250 million and more than $250 million. Packages larger than $1 billion tend to fall off in price, as a result of the smaller number of potential buyers.

Most portfolios on the market today are in the $100 million to $300 million size range. As a general rule, sellers should try to maximize the size of their package in order to reach buyers with lower costs of capital, and provide a larger asset base over which the acquisition costs can be amortized. A lender wishing to sell a $200 million servicing portfolio generally would do better simply by increasing the package size to $300 million, if possible.

Regional differences also are reflected in pricing, with the mid-Atlantic and Southeastern states remaining the most attractive. Servicing from the Midwest is next in demand, followed by packages from the Pacific Northwest and Texas. California values tend to lag, because California product generally prepays faster, carries no escrow funds and is in plentiful supply, at least currently.

Non-traditional servicers

When the RTC began selling the assets of failed thrifts at low prices, investors with no previous experience in mortgage servicing took note. At that time, stocks and other investment opportunities were performing sluggishly and the high-yield, junk bond market was collapsing. Large investors, therefore, began looking at RTC offerings. When they saw that $1 million could purchase a sizable portfolio, and then figured the expected rate of return, servicing began to look very attractive as an investment.

Today, some of those early investors have found that runoff has exceeded their expectations. Now some are paying more to buy non-RTC servicing, in order to meet their capacity needs at a time when little RTC product is on the market.

If they don't want to pay the higher multiples of servicing fees that conventional servicing portfolios are commanding, alternative products offer more-attractive prices. For instance, buyers are bidding conservatively on five- and seven-year balloon loans now, due to the short performance histories available by which to judge this product. Most servicers forecast progressively higher prepayments each year for balloon mortgages, so that the portfolio is for all purposes gone when the note comes due.

However, some servicers believe that many homeowners using these loans have specific plans to sell at a set time, at least three or four years away from the point of origination. For that reason, they don't expect to see much in the way of prepayments during the first year or two. They reason that a borrower who anticipated moving more quickly probably would have selected an adjustable-rate loan, instead.

Other product prices

Prices have risen on adjustable-rate mortgage (ARM) portfolios, because their prepayments slow as interest rates drop. ARM prepayment rates are just 15 percent to 20 percent this year, compared to 25 percent to 30 percent in previous years. Regulatory uncertainty has hurt GNMA servicing values ever since the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) was passed in the wake of the S&L crisis.

Non-conforming and jumbo loans also offer servicers unique opportunities today. Last year's production of non-conforming loans totalled more than $100 billion, and more than a third of those loans were securitized. Issuance of these "private label" MBS have grown from $800 million in 1986 to $49.3 billion last year. RTC transactions accounted for about $9 billion of that amount in 1991.

More secondary market sales mean that uniformity is increasing in these loans. Jumbo ARM product today is controlled more by capital market requirements than it is by the portfolio needs of large thrifts, the opposite of what was true a few years ago.

The total percentage of securitized loans is rising for the industry as a whole. One byproduct of this trend is it is becoming easier for servicers to build large portfolios to benefit from economies of scale. Not that many years ago, there were few servicers holding portfolios larger than $1 billion. But today, dozens of firms own more than $10 billion in residential servicing rights.

The outlook

Because servicing rights are a long-term asset, it is important to protect them from prepayments, delinquencies and legislative burdens. Servicers continue to become more astute at handling these different functions in order to build future values.

In today's environment, servicing management is getting more exact in its valuation of the servicing portfolio. Servicers are recognizing that economies of scale derive not just from large numbers, but from holding the types of loans that they can service profitably. Firms are refining their operations, accordingly and more accurately defining their needs in order to generate greater returns from their portfolios.

Steven Tannehill is senior vice president of Countrywide Servicing Exchange, a subsidiary of Countrywide Credit Industries, Inc., the parent company of the nation's largest mortgage banking firm.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:loan servicing
Author:Tannehill, Steven
Publication:Mortgage Banking
Date:Oct 1, 1992
Words:3172
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