QUESTION
We are considering whether to sell our mortgage servicing rights. This
has been a long, drawn out process of complicated decision-making. At this
point, we are still struggling with how to determine the valuations. Perhaps
there is a given set of valuation criteria that we could use. Essentially, we
just want to be sure we are including the basics in our valuation. Is there a
set of valuation data sets that we should be considering in our valuation
approach?
ANSWER
Servicers Compliance Group, our affiliate, handles due diligence for
virtually all aspects of mortgage servicing, so this is a subject with which we
have considerable familiarity. First, it is important to define “mortgage servicing rights,”
often referred to by the acronym “MSR”. At the most rudimentary level, MSRs are
the capitalized value of the right to receive future cash flows from the
servicing of mortgage loans. The concept of capitalized value asserts that the
current value of an asset can be determined based on the total income expected
to be realized over its economic life span. Those cash flow periods are the
anticipated earnings, as discounted (viz., given a lower value), so they take
into account the time value of money.
MSRs are considered a source of value derived from originating or
acquiring mortgage loans. Because residential mortgage loans typically contain
certain features, such as a prepayment option, borrowers often elect to prepay
their mortgage loans by refinancing at lower rates during declining interest
rate environments. But, when the refinance occurs, the cash flows generated
from servicing the original mortgage loan are terminated. Thus, the market
value of MSRs is extremely sensitive to changes in interest rates. For instance,
the MSR market value tends to decline as market interest rates decline and
increase as interest rates rise.
It is usual to capitalize MSRs on the fair market value of the
servicing rights associated with the underlying mortgage loans at the time the
loans are sold or securitized. Generally Accepted Accounting Principles (GAAP)
requires that the value of MSRs be determined based upon market transactions
for comparable servicing assets or, in the absence of representative market
trade information, based upon other available market evidence and even modeled
market expectations of the present value (PV) of future estimated net cash
flows – such as internally developed discounted cash flow models to estimate
the fair market value – that market participants would expect from servicing.
Obviously, valuation requires considerable expertise. I offer here a
few of the many possible ways to process assumptions in a valuation of MSRs.
This outline is by no means comprehensive. It assumes that MSRs are carried at
estimated fair market value.
- Prepayment This is the most significant driver of MSR value based on the actual and anticipated portfolio prepayment behavior. Prepayment speeds, sometimes referred to as “velocity,” represent the rate at which borrowers repay their mortgage loans prior to scheduled maturity. As interest rates rise, prepayment velocity generally slows down, and as interest rates decline, prepayment velocity generally accelerates. When mortgage loans are paid off or expected to be paid earlier than originally estimated, the expected future cash flows associated with servicing such loans are reduced.
- Discount Rate The cash flows of MSRs discounted at prevailing market rates, which often include an appropriate risk-adjusted spread.
- Base Mortgage Rate (BMR) This is the current market interest rate for newly originated mortgage loans. It is considered a key component in estimating prepayment speeds of a portfolio because the difference between the current BMR and the interest rates on existing loans in the portfolio is an indication of a borrower’s likelihood to refinance.
- Cost to Service Servicing costs are based on actual expenses directly related to servicing. These servicing costs are compared to market servicing costs when market information is available. It is advisable to include expenses associated with activities related to loans in default.
- Volatility This is an assumption that represents the expected rate of change of interest rates. The rate of change is often notated with this sign Δ and is referred to as “Delta”. Without getting too technical, the Delta is used in valuation methodologies to place a theoretical boundary around the potential interest rate movements from one period to the next.
As you proceed with your valuation approach, it is important to reconcile
actual monthly cash flows to projections, which means reconciling actual
monthly cash flows to those projected in the MSR valuation. After each such
reconciliation, an assessment should be undertaken to determine the need to
modify the individual assumptions used in the valuation.
Jonathan Foxx
Managing Director
Lenders Compliance Group
