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Fallout from Washington.

Washington's shadow looms as the servicing business is eyed with more intense scrutiny.

As the 101st Congress moves into the homestretch before lawmakers go home to campaign and the action gets hot and heavy on the serious business remaining, servicing is getting caught in the crossfire. In the current budgetary environment, every tax cut or spending increase must be paid for with money taken from someone else's tax preferences or spending programs. Such an environment encourages lawmakers to leave no substantial revenue rock unturned or no industry underinvestigated as a potential bankroller for a package of tax cuts or spending hikes.

For a long time, the mortgage servicing business was a virtually invisible industry to federal lawmakers and regulators, and thus it enjoyed a hiatus of sorts from intrusive legislation and rulemaking that made a direct assault on the profitability of the business. But not so anymore.

And while there are good aspects about the fact that lawmakers and regulators are learning more about the servicing business--which raises the odds it won't get seriously damaged unintentionally and that its importance to housing is likely to be better understood--there are some bad aspects to this as well.

In the current session, both a major tax bill (H. R. 4210) that was stopped short of enactment only by a presidential veto, and a bill (H.R. 3542) introduced by the powerful chairman of the House Banking, Finance and Urban Affairs Committee requiring interest payments on all escrows, would significantly erode the value of servicing if they were to become law. The tax bill provision, championed by the influential chairman of the House's tax writing committee, would have doubled the amortization period for servicing--thus seriously reducing valuable depreciation benefits, while the escrow bill would require 5.25 percent interest to be paid on all escrow accounts retroactively. So, servicing has clearly come in for some scary close calls in this session of Congress, and it's not over yet.

Furthermore, it's not just the Congress that has been the scene of potentially negative developments for servicing. Regulatory actions originating out of Washington, D.C. during the past year or so also have had a significant impact on the servicing market and on the active players still buying servicing.

To look further into these developments, Mortgage Banking approached some professionals whose job it is to value and sell servicing every day to see how these machinations in the nation's capital have affected the buying and selling of servicing. In a three-way interview, we spoke with key members of the servicing consulting and brokerage firm of Cohane Rafferty Securities, Inc., in Harrison, New York, to get an industry reading on what's taking place in Washington. We spoke with Thomas J. Murray, managing director with Cohane Rafferty, based in Englewood, Colorado, Elizabeth Workman, executive vice president and head of the analytics area of Cohane Rafferty, where she has overseen the development of the complex models used to estimate the value of servicing portfolios, and Bill Curley, executive vice president of sales and trading.

We asked all three for their thoughts on some of the critical federal government developments that have cast a cloud over the servicing market in recent times.

MB: Some legislative proposals introduced in the current session of Congress would have a major impact on the value of servicing if enacted. The one that comes to mind first is the Escrow Account Reform Act of 1991 introduced by House Banking Committee Chairman Henry Gonzales (D-TX). The provision that people in the servicing business seem most concerned about is the one requiring interest on all escrow accounts--both existing and new--at 5.25 percent. Could you describe the impact on servicing values if such a provision were to be enacted?

Workman: It will adversely affect the value of any servicing that has escrow balances and where, currently, the servicer is not required to pay 5.25 percent interest in those balances. But the precise impact will vary according to the facts and circumstances of the particular institution and the nature of its portfolio. We've done quite a lot of sensitivity analysis regarding the impact of this legislative proposal on servicing values. As an example, I looked at a sample portfolio of Fannie Mae [mortgage-backed security] MBS loans in the state of Minnesota.

In the case of conventional loans, currently in Minnesota, the payment of interest on escrow balances is not required if the escrow is maintained in connection with a loan for which the original principal balance exceeded 80 percent of the lender's appraised value at the time loan was made. Otherwise, a rate of not less than 5 percent per year must be paid. So, for conventional Minnesota loans you might or might not be already paying interest on escrow deposits.

Given a hypothetical 30-year, fixed-rate, current note rate, Fannie Mae MBS portfolio of Minnesota loans for which no interest is now being paid on escrow deposits, the basis-point impact on value was about 37 basis points, or 24 percent of the value. Of course, we used specific prepayment, float earnings rate, discount rate and other assumptions in this analysis. The value impact I just cited is very specific to the analysis we performed.

The general point I would make is that the impact can be quite large, but it will vary according to the level of average escrow balances associated with a given servicing portfolio and whether the servicer is currently required to pay interest on escrow deposits, and, if so, at what level. For instance, in the example I just mentioned, we assumed a starting average escrow balance of 1 percent. If the average escrow balance was .75 percent instead, the value impact of going from no interest paid on escrow balances to 5.25 percent was 28 basis points, or 19 percent.

Murray: What you're also saying is that if you were in a state such as California, where [the required interest on escrow accounts is] already 2 percent, that the marginal impact is less.

Workman: That's right. Using my example of conventional Minnesota loans, if the servicer is already paying 5 percent on this portfolio (and assuming the 1 percent average escrow balance assumption), an increase to 5.25 percent would only affect the value by a couple of basis points. The servicer cares about the negative impact of the legislation, but the impact isn't as dramatic in this case, or as Tom indicated, if one goes from 2 percent to 5.25 percent. And again, if I don't have any escrow deposits to begin with, for example, California servicers tend not to have highly escrowed conventional portfolios, it's not going to impact me as adversely as some other portfolios from other parts of the country. So you've got to look at a variety of issues to determine the value impact for specific servicing portfolios and servicers.

Murray: The retroactive nature of the provision requiring interest on escrows that is part of the bill is extremely significant. It is important from a standpoint of what accounts are involved for record-keeping purposes and also for the costs related to loans that previously were not covered.

Curley: Another point of interest is that even though this [provision in the Gonzalez bill] can have a substantial impact on the value of your servicing, there are very few bidders that are now taking that into account when bidding on servicing. There are maybe one or two bidders that we are aware of, that have some type of contingency in their bid letter [protecting them, should] this bill go through in its current form. The main reason most bidders are not doing so is due to the fact they do not believe the bill will pass in its current form.

MB: Why do they believe that the bill will not pass in its current form?

Curley: Because in the current interest rate environment, with the prime around 6.5 percent, a 5 1/4 percent required interest rate on escrow accounts is completely unfair to the lender. [The] required interest rate must take into account the cycles of interest rates.

Workman: There are servicers who are not even earning that much on their custodial balances now, depending on their particular circumstances and ability to make use of the funds.

MB: Let's say somebody paid a certain price for servicing with a substantial amount of escrow balances in the package and there is no interest required on escrows in the states where the concentration of loans comes from. If the Gonzalez bill does go through, requiring interest retroactively on all existing escrow accounts, how much does that servicer stand to lose in the value of that asset they paid for?

Murray: You've established now that it has substantial escrow balances. Let's just assume 1 percent and that they're not currently paying any interest to borrowers on those balances. If it's recently originated product (so you're assuming that the prepayments are not astronomical) then I think that you're talking about the value decreasing by approximately 25 percent.

MB: On the issue of whether these added costs would be passed on to consumers in terms of higher mortgage rates, if everybody had to pay interest on escrows, is there anybody out there that would absorb the cost and try and get a market share edge by doing that?

Curley: That is a function of the market. It is natural for an industry to pass on additional costs to the consumer. However, it will depend entirely upon how competitive the origination market is in a given area. In some markets, the entire cost will be passed on to the consumer--however, in a more competitive market such as the Washington, D.C. area, it may be modestly absorbed by the originators.

MB: One of you mentioned that a few bidders in the marketplace have modified their bidding contracts around the prospect of the Gonzales bill passing. Has it prompted anyone to temporarily get out of the market for buying servicing in order to wait and see what's going to happen?

Curley: Not that we are aware of. Companies that have budgets to buy servicing are going to continue to do so--especially considering the low-coupon portfolios that are currently out in the marketplace.

Murray: It's the same issue as with [Ways and Means Committee Chairman] Rostenkowski's longer amortization provision for purchased mortgage servicing rights. I think people are trying to be as optimistic about it as possible and not factor [these proposals into their bidding activity.] But if either one should become law as proposed, there would be a downward impact on values.

MB: Actions by federal regulators of banks and thrifts to limit the amount of purchased mortgage servicing rights that can be counted towards core capital has had a definite impact on the servicing market. Can you explain what the current status of that policy is and then discuss how it's affected the servicing market?

Workman: The Office of Thrift Supervision (OTS) lets thrifts recognize purchased mortgage servicing rights, or PMSRs, towards capital up to 50 percent of core capital, subject to fair market valuation guidelines. The Office of the Comptroller of the Currency (OCC) allows banks to count PMSRs only up to 25 percent of core capital. These limits have definitely had an impact in terms of the active servicing players that are able to buy servicing, and it has created some sellers of servicing that were formerly buyers. For thrifts, the 50 percent limit is a higher level than was originally proposed, so this regulation is better [for them] than was initially anticipated, but certainly having any limitation has had an adverse effect.

Murray: We're in the process of selling several large mortgage companies, and financial institutions represent a minority of interested parties [who are potential buyers]. If you talk to the banks and thrifts who you would otherwise think would be interested, they will say that because of capital limitations, they are better off just buying branches and deposits rather than buying mortgage servicing.

Workman: Part of the IPO (initial public offering) activity that is going on now is geared to relieve regulated institutions of the capital constraints that they're under from having mortgage banking entities or divisions.

MB: What percentage of the former bank and thrift buyers of servicing have now shifted out of that capacity because of the 50 percent limit on the amount of purchased servicing that can be counted toward capital?

Curley: Again, it's a very difficult question to answer, but if you were to look at the bidders three years ago and look at the bidders today--let's say you looked at the top 10 bidders--only two of those bidders three years ago would still be bidding today. Eight of them would be gone; most of them were thrifts closed by the RTC. They have been replaced with nonregulated institutions, as well as regulated institutions that have realized that the returns on RTC servicing acquisitions make it an attractive and extremely profitable business. Now they're faced with a situation where the returns are going downward and they're going to have to make some decisions. But I would say that for each one of those bidders that we've lost, we've replaced them on a one-to-one type of scale.

Murray: I think we should note that in our recent auction of [Bloomington, Minnesota-based] Knutson Mortgage Corporation we had more than 20 offers. And I think we only had two financial institutions [making bids]. I'm sure that before capital restrictions, at least half the offerors would have been financial institutions.

MB: How risky an asset is purchased mortgage servicing? Does it deserve this kind of capital treatment, or is this an overly conservative limitation?

Murray: It has more risk than Treasury securities and, therefore, ought to be purchased at a higher yield, but the risk is measurable. I think that's what's important. It is not like investing in a commercial office building that is particularly susceptible to risk of local economic problems and vacancies. With servicing, prepayments and defaults are the primary risks, and while estimates are not perfect, they are pretty good at predicting future performance.

Curley: One other point is that in the last three years, just as some of the people--the bidders [for servicing]--have disappeared, the market, in addition, has become more efficient. If we had an auction three years ago on a $300 million national servicing portfolio, the spread between the high bid and the low bid would have been more than 100 basis points. Now the spread is usually somewhere around 30 basis points. So you can definitely measure the value of that servicing in the market a lot better now than you could three years ago.

MB: Another Washington policy move that has affected the servicing market is the FDIC's repudiation of some servicing purchase contracts and some specific provisions in servicing contracts involving servicing from failed institutions. The known cases to date include Sears Mortgage Corporation, [Riverwoods, Illinois,] Source One Mortgage Services Corporation, [Farmington Hills, Michigan,] and then more recently, there have been press reports about a lawsuit brought against the FDIC involving a contract with a termination fee that was repudiated by the FDIC. How has this action by the FDIC changed buying behavior and prices paid for servicing that comes from FDIC-insured institutions? Can you give some specific examples of the impact on specific deals?

Murray: That's one that we're specifically involved with now--FDIC- and RTC-controlled properties. In our initial meetings [with the FDIC], we discussed the impact [on the offers for the companies being sold] of not having FDIC representations and warranties [offered with the servicing] and/or [some indication of] their intention not to repudiate agreements. We estimated in one case that there could be up to a 50 percent price differential with or without these assurances. We broke that down [by estimating that] the first 25 percent would be related to the fact that buyers would discount the price because they couldn't have any guarantees of what future losses would be. The other 25 percent would come from the fact that far fewer bidders, specifically financial institutions, would be interested in something without guarantees like that. I think [the FDIC's] settlements [with lenders whose servicing contracts were repudiated] came out so that everybody walked away fairly happy. Our belief is that they [the FDIC] understand that they just can't do that and continue to get a full price [for the servicing they are trying to sell from failed institutions].

Curley: Having said that, they are, to some extent, the only game in town for certain types of returns [on servicing being sold]. The buyers that are out there buying the clean, conventional servicing in the private market are looking at substantially lower returns than buyers of RTC and FDIC product. So, although it definitely is in the back of people's minds, it hasn't had a dramatic impact that we have been able to quantify.

MB: The FHA reforms that were implemented last July are now pretty convincingly showing up in terms of reduced volume of new FHA originations. One could conclude that this has created a shortage of new FHA originations. And because FHA originations are what make up GNMA servicing, along with VA loans, are there any signs in the marketplace of a shortage of supply of new GNMA servicing? Are there any other effects on the servicing market of this reduction in FHA volume?

Murray: I'll leave to Liz and Bill the impact on portfolios, but I can tell you from the origination end that if it weren't for FHA ARMs, there wouldn't be much FHA production. Simply because the first-time homebuyers that have relied on FHA loans can't afford the up-front cash.

I suppose the question is: is there less supply now? I know there's less origination and everybody has their own reasons for it. I think people out on the street say the reason is clearly because of the up-front cash requirement, and that is more important than other factors.

Curley: Yes, there is definitely less GNMA product in the market now than there was a year ago. Many of the large GNMA servicers have been purchased through RTC sales and have a desire to grow their portfolios.

Murray: Well, there is less new GNMA product out there.

Workman: I just want to add that you don't tend to see very new bulk-servicing GNMA packages now because of the certification issue. Whereas, you might see conventional loan bulk-servicing packages that are quite new, say, two or three months old, you don't see as many GNMA deals comprised of new loans now. I guess that's why Bill and I are pausing here, because these pools haven't had time to season enough to become actively traded.

Curley: The market for certified GNMA servicing is more competitive on a bulk basis than the market for uncertified GNMA servicing.

MB: Explain that a little bit more. Are you saying that there is no market for GNMA servicing packages that have not yet been finally certified because of the chance that they may not get certifications?

Curley: No. There is definitely a market for both, however, a certified GNMA sale is a much easier and cleaner deal. Obviously, if you have two similar portfolios for sale and one is certified and one isn't, then the certified package will receive a higher price because there will be more interested bidders.

Workman: It only takes one missing document to hold up the certification.

Curley: The largest buyer of GNMA servicing in the private market last year, excluding RTC and FDIC sales, would only buy certified GNMA portfolios--they would not even look at an uncertified portfolio.

MB: If there were going to be a shortage of new GNMA servicing caused by the shortage of new FHA originations, when would signs of that begin to show up in the market? I mean, after allowing sufficient time for the certification procedures to be taken care of, when should we start looking for evidence of a possible shortage?

Curley: It takes on average seven to twelve months from origination to get a pool certified.

MB: These reforms went into place in July, so shouldn't we be seeing it now?

Curley: Yes, we should be starting to see the impact.

Murray: I think you're absolutely right. It started in July. I believe government production went down in the second half of 1991. And there is going to be lesser new FHA and, I think, VA product available for the typical servicing sales of this summer.

MB: Congress is really having a hard time refunding the RTC. How could delays in refunding RTC affect the supply of the new RTC servicing for sale that is coming down the pipeline? What kind of impact might that have on the market for servicing in general?

Curley: Well, that's probably one of the hottest topics discussed when you get a group of buyers of mortgage servicing together right now. Many of the mortgage companies that have been bought from the RTC in the past two years have been bought with the intent of growing the portfolios through RTC and FDIC purchases. The question is, how will these companies in particular replace runoff and grow their portfolios if the product coming from the government slows down? These companies, as well as many others, are used to certain return levels. If the RTC slows down, they will be forced to compete in the private market at significantly lower return levels. This, of course, can do nothing more than drive the pricing in the private market even higher.

Murray: I would say that--we see it in our company sales if not individual portfolio sales--the so-called RTC built-in discount is evaporating. Either through a supply and demand equation or just because [potential buyers of RTC servicing] see that the quality is not as bad [for RTC servicing as originally thought]--that prices are increasing for RTC product alone.

Workman: I would add to what Tom was saying [about] the fact that over the past year or so, the reps and warranties that are provided by the RTC have become much more standardized, so people are comfortable with those. They're industry standards and [I would say] that part of the [reason for the] discounting going away was that standardization process, as well as getting into some supply and demand issues. People are now looking at these [RTC packages simply] as servicing transactions, determining whether a given package is of a high quality or of a lesser quality and are making judgments on that basis.

MB: Is the financing there to make these RTC purchases? There's probably a lot of desire to buy, but where is the financing coming from? Has that been driving who can and cannot bid and as well as the profile of the bidders?

Murray: Once again, on company sales, the large majority of potential buyers are private investment groups, venture capital and LBO groups and non-financial institutions. Financial institutions will continue to finance the operating and warehouse credit needed, but only with substantial equity investment by buyers.

Curley: Not every deal that's done by the FDIC or RTC needs financing. Some of the deals that they sell are much smaller and can be easily absorbed by a small mortgage company.

MB: When will we see the end of this RTC pipeline? When will they run out of their inventory, in your best judgment?

Murray: We haven't really even hit California very hard yet. The RTC itself is struggling to get refinanced. But don't forget that any refinancing by Congress simply goes to pay off depositors in institutions that are taken over. The assets will then be sold for whatever they bring.

Curley: This is true, many buyers, for whatever reason, believe the next flood of RTC servicing is going to be coming from the California market.

MB: Is the fact that the next big flood of RTC servicing is likely to come from California affecting current prices for non-RTC packages from California that are already on the market, in your view?

Curley: No, it is not affecting current pricing. As a matter of fact, we are seeing the pricing on California servicing becoming more competitive. For example, we have had two deals in the month of March with a 50 percent California concentration trade close to five times servicing fee.

MB: So what was driving those strong bids?

Curley: Well, as mentioned earlier, there is a strong desire for current production. These portfolios both had weighted average note rates of below 9 percent. Buyers also seem to have a better handle on the prepay speeds in California.

MB: With all the runoff that has hit servicing portfolios, the demand in the servicing purchase market has shifted strongly to newly originated, low-coupon servicing. How has that bid up prices and affected the returns buyers are getting for the available supply of low-rate servicing?

Curley: There were a lot of flow deals done in the fourth quarter of 1991 and in January of 1992. Sellers were trying to take advantage of the perceived value of current and future originations. As we started to see bulk deals with similar note rates, in the eights, the pricing evened out between bulk and flow. Now, I believe, a seller's best execution is in the bulk market. Many of the flow buyers are saturated.

MB: What is commanding the most aggressive prices at this point? Could you profile what that package might be like?

Curley: Probably the ideal size package is something with a portfolio size of from $300 to $400 million, somewhat regionalized. If it's regionalized, you are able to obtain the interest of the players in your backyard as well as all the national buyers. When you have a national portfolio, only national buyers can take that in.

Murray: [Is] one region better than others, Bill?

Curley: Probably the most favorable region still is the Southeast. It has been for the last four or five years. Very close to that is the Midwest, and then, probably, national packages behind that.

Murray: And those were conventional packages?

Curley: Yes. That's a good point. One thing we have noticed about the GNMA market over the last 12 to 15 months is that it is getting stronger and stronger. It has gone from servicing prices in the 150s to servicing prices in the 180s in some cases. [This is] mainly due to the fact that some buyers have been priced out of the conventional market. Also, the risk associated with GNMA is not there like it was in the Texas era. We think the pricing for GNMA servicing will get more competitive as the year goes on.

MB: Of the buyers who are still bidding for conventional products at sharply higher prices, how much have the returns been diminished because of the higher prices?

Curley: Probably 2 or 3 percentage points. Every 1 percentage point equals about 10 basis points of value. So you probably had, after taxes two years ago, people using "ten-something" and now you have people using "eight-something."

MB: Could give me a range of returns at today's prices for conventional product, versus GNMA product, versus RTC product?

Curley: Well, as Tom mentioned earlier, it is very difficult to give prices on return ranges on RTC product because the deals are distinctly different--from $100 million of ARMs in Texas to $300 million of Fannie Mae MBSs in Michigan. I would say that buyers are associating higher returns for GNMA product than conventional product in the private market. In regard to pricing on conventional product, let's say Fannie Mae MBS in the Midwest, you would be looking for servicing multiples of more than five on 30-year and four on 15-year product.

Murray: Bill, would you say buyers may be looking at yields in a range of 12 to 15 percent before taxes?

Curley: After tax it's in the eights for that type of product. Are you talking RTC or overall market?

Murray: General market.

Curley: It's below that. The only way that you can get to the numbers that we see being paid for clean, conventional product is that you have to be using an after-tax number in the eights, and you have to be using a marginal cost number around $40.

MB: What's the marginal cost refer to?

Curley: The incremental cost of bringing on one loan. That, in my mind, is the skeleton in the closet, because if you were to talk to 100 different servicers, they would give you 100 different answers on what their marginal cost is and how you calculate it. I believe in marginal cost. However, I believe it should be applied on a case-by-case basis. Not one number for the entire year.

Murray: And what Bill is saying here is that's what's needed hypothetically to get to the price needed to be successful, because I think that's what most everybody does.

Curley: Right. To be the winning bidder those are the numbers you have to use. Janet Reilley Hewitt is editor in chief of Mortgage Banking and Real Estate Finance Today.
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Title Annotation:panel discussion; mortgage servicing business being closely scrutinized by regulators
Author:Hewitt, Janet Reilley
Publication:Mortgage Banking
Article Type:Cover Story
Date:May 1, 1992
Previous Article:Boardroom view.
Next Article:Stretching out servicing's write-off period.

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