As these are estimated with reference to backward-looking experience, analysts often adjust the models to reflect their experience adjusted for future expectations.
Investors in GSE-guaranteed mortgage pass-through certificates are exposed to voluntary and, to a far less extent, involuntary (default) prepayments of the underlying mortgages. If the certificates were purchased at a premium and prepayments exceed expectations, the investor’s yield will be reduced. Conversely, if the certificates were purchased at a discount and prepayments accelerated, the investor’s yield will increase. Guaranteed pass-through certificate investors are not exposed to the credit performance of the underlying loans except to the extent that delinquencies may suppress voluntary prepayments. Involuntary prepayments and early buyouts of delinquent loans from MBS pools are analogous to prepayments from a cash flow perspective when it comes to guaranteed Agency securities.
Investors in non-Agency securities and whole loans are exposed to the same prepayment risk as guaranteed pass-through investors are, but they are also exposed to the credit performance of each loan.
The mortgage servicing fee can be simplistically represented by an interest-only (IO) strip carved off of the interest payments on a mortgage. Net MSR cash flows are obtained by subtracting a fixed servicing cost. Securitized IOs are exposed to the same factors as pass-through certificates, but their sensitivity to those factors is magnitudes greater because a prepayment constitutes the termination of all further cash flows – no principal is received. Consequently, returns on IO strips are very volatile and sensitive to interest rates via the borrower’s prepayment incentive.
The margins illustrated by these figures demonstrate the extreme sensitivity of net servicing cash flows to the credit performance of the MSR portfolio
While subtracting fixed costs from the servicing fee is still a common method of generating net MSR cash flows, it is a very imprecise methodology, subject to significant error. The largest component of this error arises from the fact that servicing cost is highly sensitive to the credit state of a mortgage loan. Is the loan current, requiring no intervention on the part of the servicer to obtain payment, or is the loan delinquent, triggering additional, and potentially costly, payday Tennessee Jellico servicer processes that attempt to restore the loan to current? Is it seriously delinquent, requiring a still higher level of intervention, or in default, necessitating a foreclosure and liquidation effort?
According to the Mortgage Bankers Association, the cost of servicing a non-performing loan ranged from eight to twenty times the cost of servicing a performing loan during the ten-year period from 2009 to 1H2019 (Source: Servicing Operations Study and Forum; PGR 1H2019). Using 2014 as both the mid-point of this ratio and of the time period under consideration, the direct cost of servicing a performing loan was $156, compared to $2,000 for a non-performing loan. Averaged across both performing and non-performing loans, direct servicing costs were $171 per loan, with an additional cost of $31 per loan arising from unreimbursed expenditures related to foreclosure, REO and other costs, plus an estimated $58 per loan of corporate administration expense, totaling $261 per loan.
Both the prepayment and credit performance of mortgage loans are estimated with the use of statistical models which draw their structure and parameters from an extremely large dataset of historical performance
The average loan balance of FHLMC and FNMA loans in 2014 was approximately $176,000, translating to an annual base servicing fee of $440.
After prepayments, credit performance is the most important factor determining the economic return from investing in MSRs. A 1% increase in non-performing loans from the 10yr average of 3.8% results in a $20 per loan net cash flow decline across the entire portfolio. Consequently, for servicers who purchase MSR portfolios, careful integration of credit forecasting models into the MSR valuation process, particularly for portfolio acquisitions, is critical.
