Mortgage Servicing Rights

Mortgage servicing rights (MSRs) are the contractual rights to service a set of mortgage loans on behalf of whoever owns them, in exchange for a fee taken from the borrowers' interest payments. Servicing means collecting monthly payments, managing escrow accounts for taxes and insurance, passing principal and interest to investors, dealing with borrowers in difficulty and handling foreclosure where necessary. Because the fee stream has value and can be separated from ownership of the loans, the right to receive it is recognised as an asset in its own right.

MSRs are chiefly a feature of the United States, where most home loans are sold into securities after they are made and the servicing is retained or sold separately. They are held by banks and, to a growing extent since the 2010s, by non-bank mortgage companies and by investors that own the rights while a licensed company performs the work.

An MSR comes into existence when a lender sells or securitises a mortgage loan but keeps the servicing, or when servicing is purchased from another firm. A lender that originates a loan and sells it into a mortgage-backed security guaranteed by Fannie Mae, Freddie Mac or the government agency Ginnie Mae typically retains a servicing fee set as a fraction of a percentage point of the outstanding balance each year. The present value of the expected fees, net of the cost of doing the work, is the value of the right.

Rights can be transferred in bulk sales between servicers, subject to approval by the guarantor or trustee and to rules on notifying borrowers. The mechanics of taking over a portfolio, known as loan boarding, are a known source of errors, and consumer regulators supervise transfers closely.

An MSR is an unusual asset because it gains value when interest rates rise. The fee is earned only while the loan is outstanding. When rates fall, borrowers refinance, the old loans are repaid early and the fee stream ends; when rates rise, borrowers keep their loans and the stream lasts longer. Prepayment speed is therefore the main input to valuation. Other drivers include:

• Servicing cost. Performing loans are cheap to service; delinquent loans require far more staff time and may oblige the servicer to make a mortgage servicing advance to investors.
• Ancillary income. Late fees and interest earned on escrow and payment balances held before remittance add to revenue, and the latter rises with short-term rates.
• Default rates. Higher delinquency raises costs and can end the fee stream through foreclosure.
• Discount rate. The return investors demand for holding an illiquid, model-valued asset.

Because the behaviour is the opposite of most fixed-income assets, lenders regard servicing as a natural hedge for their origination business, which does well when rates fall and refinancing is brisk.

Under US accounting standards, servicing rights are recognised at fair value when the loans are sold. Afterwards the holder chooses, by class of asset, between continuing to measure them at fair value with changes going through earnings, or amortising them over the expected life of the servicing income and testing for impairment. There is no active quoted market, so fair value is estimated with models that project prepayments, costs and defaults, and it falls into the lowest level of the fair value hierarchy, which relies on unobservable inputs. Holders that use fair value accounting usually hedge the rate sensitivity with derivatives and Treasury securities, and the effectiveness of that hedging has a visible effect on reported earnings.

Bank regulators treat MSRs cautiously because their value is uncertain and can fall quickly in stress. Under Basel III, mortgage servicing rights above a threshold measured against Common Equity Tier 1 capital must be deducted from that capital, and the amount not deducted receives a high risk weight. The United States later simplified and relaxed the threshold for banks outside the largest group. The rule made holding large servicing portfolios expensive for banks and is widely cited as a reason for the migration of servicing to non-bank companies, which are not subject to bank regulatory capital rules.

The main financial risk is the sensitivity to rates and prepayments, which can produce large valuation losses when rates drop. Operational and compliance risk is also significant: servicing is governed by detailed consumer protection rules on payment handling, error resolution and treatment of struggling borrowers, and failures after 2008 led to large settlements with regulators.

The growth of non-bank servicers has raised financial stability questions. These firms rely on short-term borrowing, including a warehouse facility for new loans and credit lines secured on the rights themselves, and they must fund advances precisely when borrowers stop paying. State regulators and the agencies that guarantee the securities have responded with minimum capital and liquidity standards for servicers, covering the wider activity of loan servicing.