The basic profile of the servicing industry is continuing to change as servicing costs continue to soar. The result has been industry consolidation, driven by the need for operational scale to absorb sharply higher compliance costs. Plus, there’s no sign of this letting up anytime soon.
Mortgage Banking
February 2016
By Robert Stowe England
One way to think about the mortgage servicing business is to envision it as a payments and disbursements factory that oversees homeowners’ mortgage payments and forwards interest and principal payments to investors on $9.96 trillion in mortgages.
It’s a costly enterprise to administer and the factory supervisors must wage perpetual battle to maintain profit margins.
In the last few years, that battle has intensified as sharply higher annual costs per loan test servicers’ management skills.
In response, servicers have redesigned and rebuilt the infrastructure of their loan payment factories to handle the growing complexity and greater number of steps necessary to comply with a deluge of government regulations. Missteps, even minor ones, have become more costly because servicers face severe penalties for errors.
Indeed, the onslaught of servicing regulations has pushed loan servicing costs to the center of the world of servicing, according to Steve Harris, president of MIAC Capital Markets LLC, New York, a mortgage brokerage, valuation and advisory firm.
“In my view, the absolute most important factor in the mortgage servicing industry is the average cost of servicing, which continues to skyrocket,” Harris says.
“As the government continues to implement new regulations, as servicers continue to implement new technology and as [borrowers] require more service, those are added to the entire cost of servicing,” says Harris.
Servicing assets are known in the business as mortgage servicing rights (MSRs), which refers to the contractual rights to service the loan and are also called mortgage servicing assets (MSAs).
For owners of MSRs, it is a world of regulatory pain.
Making rules in a vacuum
Sometimes new rules are made without sufficient consideration for their impact on the ability of the industry to absorb the costs and the ability of many servicers to remain viable under higher costs, according to Paul Miller, managing director, financial services at FBR Capital Markets, Arlington, Virginia.
“The Consumer Financial Protection Bureau [CFPB] is the new sheriff in town and they’re not friendly; so a lot of servicers’ expenses have really gone through the roof,” says Miller.
The rising costs of servicing are likely to increase the sale of MSRs as more servicers are weighed down by the regulatory burden, according to Miller. In some ways, the basic challenge faced by the servicing business is not new--it’s just that the consequences have become more severe than in the past, he adds.
The return on MSRs “has been a disappointment for 15 years because they get the constant prepayment [rate] wrong every time,” Miller adds. That is, the buyers bidding on MSRs assume the prepayments are going to be lower than they turn out to be, he explains.
Worries about errors are enough when you are servicing your own portfolio, but now originators also must worry more than in the past about any mistakes made by other third parties that manage their servicing. This concern derives from the vendor regulations from the CFPB that make the holders of servicing rights responsible for errors made by others hired to do the work of handling loan payments and resolving delinquencies.
Servicers are throwing up their hands in response, according to Harris. “You’re my vendor, but you know what? You’re just an extension of me and I’m responsible for everything you do,” he says.
Compliance monitoring costs multiplying
Many in the servicing industry agree. The sheer number of regulators and monitors stepping up their scrutiny of servicing activity add to the overall costs of servicing.
“I think the regulatory cost and the compliance is getting more and more difficult,” says James Lockhart, vice chairman of WL Ross & Co. LLC, a New York-based subsidiary of Invesco Ltd., Atlanta.
“And it’s certainly not just the CFPB. State regulators, as well, are spending a lot of time scrutinizing the servicers and there are state examinations,” says Lockhart.
“To the extent someone is servicing for a bank, the banks have teams that are spending a lot of time with the servicers as well. So there’s a whole series of monitors,” Lockhart adds.
Servicers also face oversight from many powerful players and counterparties in the mortgage industry. “You have Fannie [Mae] and Freddie [Mac] looking at them. You have the rating agencies, obviously, because they have to be rated to be a servicer,” says Lockhart. “And to the extent they are servicing for various investors, you’ll have them doing annual reviews. And investors, in particular, are getting more and more detailed about their inspections of the servicers,” says Lockhart.
WL Ross jointly owns Shellpoint Mortgage Servicing, Greenville, South Carolina, with Uniondale, New York-based Ranieri Real Estate Partners. Shellpoint also owns New Penn Financial, Plymouth Meeting, Pennsylvania.
Together, Shellpoint and New Penn service $32.1 billion in loans, according to Inside Mortgage Finance, which separately ranks Shellpoint at No. 54 and New Penn at No. 77. Combined, they would rank No. 38.
Compliance execution is critical
It is not enough just to beef up operations to deal with the challenge of complying with the onslaught of regulation. Because the penalties can be so severe, the quality of a servicer’s internal compliance regime is critical to the success of the business, according to John Britti, chief investment officer at Ocwen Financial Corporation.
“Regulatory compliance in servicing is probably the most important single aspect a servicer needs to care about. You can’t compete in this business unless you are potentially world-class in compliance. I think that puts a premium on execution,” says Britti.
Ocwen services1.8 million loans with an unpaid principal balance (UPB) of $285.4 billion and is No. 7 in the rankings of all servicers, according to Inside Mortgage Finance. Ocwen is headquartered in West Palm Beach, Florida.
Regulatory compliance costs and potential penalties are a key focus of discussions within the industry, according to Bob Walters, chief economist and vice president of the Capital Markets Group at Quicken Loans Inc., Detroit. Quicken ranks No. 10 in the residential servicing lineup, according to Inside Mortgage Finance, with mortgage servicing rights for $186.5 billion in loans.
Customer service is a hallmark of Quicken’s mortgage business. The company has consistently ranked No. 1 in customer satisfaction surveys for both servicing and originations by J.D. Power, Westlake Village, California.
The necessary investment in infrastructure to achieve world-class compliance is driving consolidation, according to Walters. “More and more, you have to be very robust. You have to be a substantial size. You have to have lots of attorneys on staff. You have to have technology in place. You need to be very adept to handle the sheer magnitude of the changes,” says Walters.
“So by definition, it means the number of small servicers will be greatly diminished,” he says.
Getting out of the business
The current consolidation trend represents a complete turnaround from an earlier period of dispersion in the industry, according to MIAC Capital’s Harris.
“Over the last four or five years, we saw everyone that could conceivably apply for the servicing license indeed do so, and consequently the number of licensed servicers rose dramatically,” he says.
“That was all driven by a period of time when the markets were disrupted and the aggregators were not paying a reasonable or economic value of the servicing that was being created. So many of these folks retained servicing,” Harris explains. They turned to subservicers such as Cenlar FSB, Ewing, New Jersey, and Dovenmuehle Mortgage, Lake Zurich, Illinois, to handle the servicing for their loans, according to Harris.
That era of dispersion is now over and a new era of consolidation is underway, according to Harris.
“It’s like the market has done a 180 [degree turn]. All of these folks who had secured their license to service and went out and hired a subservicer, they are experiencing greater costs and so they are starting to think it’s time to take some chips off the table--so they’re looking to sell servicing,” Harris adds.
Smaller players are going to find it tougher and tougher to stay in the business because they do not have the scale to do so, according to Tim Neer, director of loan servicing at Colonial Savings, Fort Worth, Texas.
“We are either going to see some servicing portfolios will start to consolidate or we’re going to see subservicing play a bigger role in the marketplace--and frankly, there will probably be some smaller originators who will exit the [servicing] business,” says Neer.
Annual average cost per loan
The annual average cost of servicing a loan, tracked by the Mortgage Bankers Association (MBA) as part of the MBA’s Servicing Operations Study and Forum, is the standard industry metric for measuring servicing costs. In 2008, the annual total operating cost of servicing a performing loan, excluding interest expense, was $59 a year, according to MBA. That rose 2.5 times to an average of $156 per performing loan for 2013 and remained at that level in 2014.
The magnitude of the rise in costs for servicing delinquent and foreclosed loans is far greater. In 2008, the annual total operating cost of servicing a non-performing loan , excluding interest expense, was $482 per year per loan. That rose 4.9 times to $2,357 in 2013 before declining in 2014 to $1,965 per loan per year, a level 4.1 times higher than in 2008. Costs could rise again in the future as servicing shops have to incorporate more regulations on the way from the CFPB.
While costs per loan have come down since 2013, “that is primarily a function of assets being added to platforms being really good-credit-quality assets with lower delinquencies,” says Kevin Brungardt, chairman and chief executive officer of RoundPoint Mortgage Servicing Corporation, Charlotte, North Carolina.
The cost of servicing a delinquent loan can be 10 times the cost of servicing a performing loan, so lower delinquency rates can lower overall cost per loan at a given servicer as well as across the industry, Brungardt explains. Indeed, MBA data shows an even greater multiple. In 2014, the $1,965 average annual cost to service a non-performing loan was 12.6 times higher than the $156 average annual per-loan cost for performing loans.
Building a servicing rights pipeline
Higher costs are driving a growing number of smaller originators to look into selling their MSRs to larger servicers, according to Neer at Colonial. The servicing-release premiums they can earn can, in turn, help them expand their origination capacity, he adds.
Originators, however, remain concerned about how their customers will be treated by the servicer that takes over the payments processing of the loan.
“They key is they have to deal with a business partner on the servicing side that is going to treat their customer right,” says Neer. “At the end of the day, if a customer gets unhappy about how I service the loan, they are going to call their originator and talk to the loan officer. They are not going to call me,” he says.
Colonial is both an originator and servicer of loans it originates, as well as being an acquirer of servicing rights and a subservicer. The savings bank originates mortgages from two retail branches, as well as through its own Internet lending channel. Colonial also has a significant origination channel for credit unions. “We actually do the origination process for them and put those loans in a portfolio for them,” says Neer.
The biggest driver of Colonial’s growing servicing portfolio, however, is its participation in Fannie Mae’s and Freddie Mac’s bifurcation programs with a dozen originators. In this program, participating lenders originate the loans and sell them to the GSEs at the same time that Colonial obtains the servicing assets. Servicers have to apply for approval by a GSE to participate in the bifurcation program. Originators can participate if they form a relationship with an approved bifurcation servicer.
The bifurcation arrangement relieves some of the mounting regulatory burden by requiring only the originator to hold the origination reps and warranties made to the GSEs while requiring only the servicer to be responsible for the servicing reps and warranties.
Colonial’s bifurcation program with originators allows it to acquire new flow servicing on $3 billion to $4 billion in loans a year. The program has helped Colonial grow its business to managing servicing operations on $24.6 billion in loans, according to Neer.
Colonial has a variety of ways to customize its servicing to the needs of its origination partners, says Neer. For example, it can provide access to the payment portals at Colonial. Colonial can also send out billing statements, if that is what a client needs.
Colonial’s portfolio is made up entirely of prime mortgage loans. “We have a very clean portfolio. We pick and choose who we deal with,” says Neer.
Colonial has a low 3 percent delinquency rate on the loans it services, he says. This, in turn, allows Colonial to have a low average annual cost per loan to service. Even so, compliance costs have risen 36 percent in recent years from an average annual cost per loan, going from $140 to $190 per year, according to Neer.
Many ways to consolidate
A rise in the share of loans handled by subservicers is one of several ways the consolidation can occur, according to RoundPoint’s Brungardt. Larger servicers may offer a range of options to smaller servicers seeking to get out of the business.
“Some [buyers of servicing] will say, OK, I’ll take on the operating company. Or I’ll shut the operating company down for you. Or help you with that, because it is a complicated process. Or I’ll purchase the assets and/or I’ll subservice for you,” Brungardt says.
Subservicers are gaining share, according to estimates by Inside Mortgage Finance. In 2014, subservicers managed an estimated 11.9 percent of total mortgage servicing, according to Inside Mortgage Finance. The subservicing share rose to 15.8 percent by the third quarter of 2015.
The consolidation wave in servicing is more likely to expand the role of the top 15 or 20 servicers, according to Brungardt. “I think we’ve seen some significant action in that direction over the last six months to 12 months, and in the next 24 months we’re going to see more significant consolidation action,” he says.
Over time, larger servicers may increase their domination over the market because the market has become “a complicated scale game,” says Brungardt. The more demanding and costly that servicing becomes, the more it raises “significant barriers to entry outside the top 15 or 20,” he says.
RoundPoint ranked No. 24 as the servicer of $56.4 billion in loans at the end of the third quarter of 2015, a level 62 percent higher than a year earlier, according to Inside Mortgage Finance. The unpaid principal balance of loans it services rose to $59.9 billion as of the end of 2015, the company reports.
RoundPoint started out in 2007 as a specialty servicer of distressed servicing assets acquired in a bulk purchase. However, the company switched gears in 2012 and decided it would form business partnerships with 30 to 35 mostly midsized independent mortgage bankers to grow the business primarily by buying the servicing rights to newly originated mortgages being sold to Fannie Mae, Freddie Mac or into loan pools backing Ginnie Mae securities.
“We loved the credit profile. We loved the historically low average weighted coupons. We loved the customers,” Brungardt says. “You can grow in a methodical way by taking on these originations on a monthly basis, especially on a flow basis rather than a bulk purchase,” he adds.
Smaller servicers that want to stay in the servicing business are going to need to expand operations--but not before that they make necessary investments to handle the new business, according to Brungardt.
“First you have to build up the compliance infrastructure and the infrastructure to service the customer--and that’s a very expensive proposition and it’s also a time-consuming proposition,” he says. “Then you need to add the assets secondarily.”
Basel III
The high capital costs for holding servicing under Basel III capital standards remains a factor in the ongoing shifts in who originates and retains mortgage servicing and who buys or sells it, either on a flow or bulk basis, according to Austin Tilghman, chief executive officer at UCM Inc., a Greenwood Village, Colorado, firm that advises companies on hedging their servicing rights.
“Basel III is a very, very big deal,” Tilghman says.
Prior to Basel III, the Office of the Comptroller of the Currency (OCC) allowed banks and thrifts to count the value of their mortgage service rights for as much as 50 percent of a bank’s common equity tier 1 capital, also known as core capital. The risk weighting was 100 percent, meaning the capital rules allowed the banks to count the full fair value of the asset as part of their common equity tier 1 capital.
Under the new rules, mortgage servicing assets are limited to 10 percent of common equity tier 1 capital and the risk weighting rises to 2.5 times the value of the asset by 2018. “A 250 percent risk-based weighting makes it a toxic asset,” Tilghman says. Further, there is a severe penalty for holding more than 10 percent of common equity in MSRs.
Since mortgage servicing assets come with escrow balances, that provides a bit of an offset to the 250 percent risk weighting, according to Tilghman. The escrow balances include principal, interest, taxes and insurance, and are treated like demand deposits by regulators. The value of those deposits can sometimes come close to the value of the mortgage servicing assets and lower the effective capital cost of servicing assets from a risk weighting of 250 percent to a level of around 125 percent, according to Tilghman.
Basel III has prompted a shift of ownership of mortgage servicing assets from larger depository institutions to privately held mortgage companies and hedge funds, Tilghman says.
Even so, banks have a significant advantage over privately held mortgage companies because they have more access to cash and liquidity. “They can borrow from the Fed and use the Fed Funds market, and they can mark to market their hedges with cash,” says Tilghman.
At privately owned non-bank mortgage companies, “cash is a rare commodity, and they may need a line of credit or have to sell off servicing to raise cash to allow them to mark to market their hedges,” according to Tilghman.
Basel III capital standards for servicing continue to make it less attractive for small banks to hold servicing assets, according to David Fleig, president and chief executive officer of MorVest Capital LLC, a Dallas-based company that helps companies finance the purchase of servicing assets.
“Even regional banks of a decent size are getting to the point where they’ve got to worry about that. We know of one bank that likes MSRs but sold some servicing in the fourth quarter of last year because it was beginning to get to be too big a number relative to the size of the bank,” says Fleig.
Basel III’s impact will continue to favor non-banks, according to Fleig. “I think the market share of non-bank-owned servicing is going to continue to drift upward,” he says.
The heavy capital charge for MSRs is another reason that banks want to originate only the best credit-quality mortgages, according to Kevin Wall, president of First American Mortgage Solutions, Santa Ana, California.
“If you are going to have to hold capital against an asset base, what do you want that asset base to look like?,” Wall asks. Depository institutions, he says, are likely to conclude that they will want a servicing portfolio that’s likely to have very low delinquencies or fit into a company’s overall business strategy, such as lending mostly to customers within the bank’s geographic footprint. Banks also want MSRs that will reliably generate profits, according to Wall.
Ocwen’s Britti suggests that the claims about the impact of Basel III on the willingness of banks to hold mortgage servicing assets may be overstated.
“In the beginning, I think it did affect some of the bank’s strategic thinking around correspondent lending and wholesale lending,” Britti says. “You do hit an inflection point which makes the capital cost of holding servicing punitive.”
Concerns about Basel III, for example, have been a factor in decisions by banks to keep or end their wholesale origination channels, Britti suggests. “It is a lot of the reason why banks have become skittish about brokers is that they are essentially being held to account for what the broker does,” he says.
Correspondent lending is somewhat similar, according to Britti. The margins in that business are relatively thin, he says. That may make the risk too great for the anticipated income.
Retail mortgage origination and servicing, by comparison, looks a lot more attractive. “That’s much less risky--but [servicing from retail operations is] also much less likely to run into this Basel limitation,” says Britti.
Private equity
The enduring appetite of private equity and real estate investment trusts (REITs) continues to bring liquidity into the servicing asset market, according to Brett Schaffer, president of Phoenix Capital Inc., Denver. The firm, he says, has helped broker bulk and flow sales of mortgage servicing assets of $1 trillion of loans over the years, including about $500 billion in bulk sales of legacy delinquent loans from Bank of America.
“Liquidity came back into the market in 2012,” Schaffer says, “when private-equity players and REIT players became a servicing takeout for the mortgage banking community and, to some extent, the banking community that wanted to sell MSRs.”
This infusion of private funding helped build from scratch the servicing powerhouses of Ocwen Financial; Nationstar Mortgage LLC, Dallas; and Green Tree Lending, a St. Paul, Minnesota-based company acquired by Walter Investment Management Co. in 2011, that was merged in 2015 with originations powerhouse Ditech Mortgage Company, Fort Washington, Pennsylvania. The merged company was renamed Ditech Financial LLC.
While Ocwen is barred for now by regulators from acquiring servicing assets, Nationstar and Ditech have been growing their servicing portfolios at a slower pace than a few years ago.
The regulators are having second thoughts about the impact of costly regulations driving servicing out of the banking sector, according to Miller at FBR Capital. “I think the regulators have backed off a bit now because what they found was--yeah, we want to push servicing out of banks--but then they ended up pushing it into much more unstable capital structures.”
The influx of new investors has invigorated the market for mortgage servicing rights. “It was like going back to the old days in the early 1990s, where you could go to market and have 20 interested parties--and 10 to 15 of them bidding on any particularly servicing transaction that was interesting to them,” says Schaffer. “The vast majority of the purchasing is going on among private-equity and REIT players, non-financial institutions,” he adds.
The current high 9.5 percent yield on MSRs makes them attractive to hedge funds, according to UCM’s Tilghman. Hedge funds also like the fact MSRs make good hedges against bond portfolios because they rise when bond values fall, according to WL Ross’ Lockhart.
Ten private companies with MSR assets for $50 billion to $100 billion in loans were the primary drivers and buyers of MSRs in 2015, according to Schaffer. “The second, third and fourth wave of private-equity entrants--and I don’t think any of them have gone public--those have been the dominant buy side of the market,” he says.
Part of the attraction is the expectation that rising interest rates will push up the value of those servicing assets, Schaffer explains. But the high yields are a key attraction in a time of low interest rates. “Originally they were looking at double-digit percentage yields as the return on the MSR,” Schaffer says. “I’m sure some of the early entrants earned quite a bit of that return. But then as other guys came, the market started floating back up,” he says, as bidders for MSRs had to pay more for them and the return on the investment moved down.
While the pricing of servicing transactions has come down some from their 2014 peak, “We’ve seen what I call pretty fair market values today,” Schaffer says.
The slightly weaker market for MSRs is due in part to prepayments in 2015 being higher than models predicted in 2013 and 2014, when the servicing rights were acquired, according to Schaffer. “That causes buyers to take down their pricing a bit. So we are seeing some softening of pricing. I’d say pricing is now more in line with the current view of the prepayment performance of an MSR,” he says.
While the private-equity buyer appetite has grown, the supply of mortgage servicing rights from new originations has also risen to meet the demand. The supply of flow servicing rights from originations has been boosted by the decision by the Federal Housing Finance Agency (FHFA) to require Fannie Mae and Freddie Mac to raise guarantee fees for larger originators that have enjoyed a discount for many years to be more in line with the higher fees paid by small originators, make for a more level playing field among originators.
“So there isn’t the arbitrage that the big players enjoyed versus almost any mortgage player,” says Schaffer. “So that helps explain why there are more mortgage banking originations. They are not disadvantaged in the way they came to be, especially [during] the early to mid-2000s,” says Schaffer.
The appetite of private equity and REIT servicers who want to own more servicing thus allows more originators to come online who just want to be in the origination business and not in the servicing business. This leads to more consolidation in the servicing industry but more dispersion in originations, according to Schaffer.
The mortgage banking business is likely to face a squeeze in 2016, according Tilghman at UCM. Higher interest rates will compress margins for originators, which could slow the pace of originations, he says. “Rising interest rates may continue to push up the value of the dollar and reduce U.S. competitiveness abroad, and create a drag on economic growth,” he says.
Despite the headwinds, demand for servicing assets is likely to remain strong, according to Tilghman. “I do see continued investment in servicing by non-banks and hedge funds. I do see that,” he adds.
Rising interest rates will push up the value of MSRs, and this will impact the servicing industry. “You will see folks stay with their current mortgage longer,” according to First American Mortgage Solutions’ Wall. “Refis will drop and the life of the interest-only [IO] or IO strip will be extended, according to Wall.
“As rates increase, the prepayment speeds elongate, meaning an asset will stay on the books for a longer period of time because that propensity to refi will go down as rates increase,” says Wall. “So it extends the life of the original loan because of its current rate structure as compared to market [rates].”
Shifting dynamics
The shifting dynamics in the servicing industry seem likely to boost consolidation. For one thing, the smaller servicers are going to have to exit the business in one way or another because they cannot keep up with the rising costs of compliance. This favors consolidation of the industry into the hands of the larger servicers, especially those with the best compliance systems and superior customer service.
Some originators will want to hold on to their MSRs but farm out the work, which of course favors the subservicers.
Finally, the appetite of private investors, REITs and hedge funds favors consolidation of more share into the hands of servicers whose mortgage servicing portfolios lie in the $50 billion-$100 billion range--the tier of servicing players just below the top 15.
The one thing that could mitigate the regulatory pressures driving consolidation is for the regulators to ease up, according to Miller.
“I know that regulations tend to get wound down over time,” Miller says, “but there’s no way President Obama will unwind one of his signature policies.” Thus, he adds, any easing that might conceivably occur will have to wait until after this year’s elections. MB
Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at
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