Market Update for MSR Sales: Q4 2020

…from the desk of Phil Laren

MSR values and MSR sales have been top of mind recently for a number of our clients, both on the buy and sell side. This is mostly due to the disruption in the secondary market in March due to COVID shutdowns. That disruption caused the aggregator bid for MSRs to approach zero (or even in some cases, below zero). Forbearance uncertainty and record origination volume were the principal contributors to this pull back.

In addition, and for similar reasons, the co-issue market bid disappeared in March, and bulk MSR offerings were mostly withdrawn except for a few “fire sale” offerings that were marketed as a result of seller cash needs.

This letter will discuss what has happened in the six months since that MSR market collapse, and where we expect the market to go in the near future.

Immediate (Early Spring) Consequences of the Collapse in the MSR Bid

The immediate consequences of the collapse were predictable:

• Small to medium sized originators without agency approval rushed to get approval in order to start retaining servicing.
• Small to medium sized originators, who already had agency approval, but were normally not holders of servicing, decided to retain much more servicing than they had in the past.
• Medium to large size seller/servicer/originators, who usually sold production through Co-issue or bulk transactions held their newly originated MSRs, growing their balance sheets accordingly.

As a result, most medium to large originators are holding much more servicing than they had planned for. Servicing in general, is an asset that demands high amounts of cash to hold. Not just because you forgo the cash from selling the MSR thru a correspondent sale or co-issue at origination, but subsequently due to the advances (both P&I and T&I). Fortunately, the origination market post March has been very robust and profitable, due to both the refi volume (and, also the purchase market, which has remained strong during the pandemic) and due to the high margins that refi booms often create. So most originators are flush with cash at this time and not in any rush to sell MSRs.

Subsequent (Summer-Early fall) Consequences of the Collapse in MSR Bid

Financial Markets, like Nature, abhor a vacuum. When bidders for tradable collateral (such as MSRs) disappear, yields rise and opportunistic investors enter the market as “buyers of last resort”. Which is a euphemism for “they pay a lot less”. In normal competitive markets, this would mean private equity firms and hedge funds would jump in to replace the usual Aggregator and co-issue buyers. But this does not happen right away because:

• There are barriers to entry for MSR. Statutory and regulatory, Operational, familiarity with market, identification of an exit strategy
• There were other COVID related opportunities. (non-mortgage investment opportunities, the brief collapse of the non-QM market, financing financial institutions whose warehouse lines were cut, buying REIT portfolios) that were also high yield and easier to participate in than servicing
• There were uncertain risks (How bad forbearance? How long the virus?)

So the only entities capable of jumping in immediately were other mortgage companies, who were not normally aggregators or co-issue buyers.

But even here, new entrants had a problem. Fannie Mae and Freddie Mac will not approve a new co-issue buyer overnight. The Ginnie Mae process is more cumbersome and Ginnie loans present relatively more risk and operational challenge, so new co-issue players were not instantly available.

And although MCT helped with the BAM MarketPlace to quickly introduce new buyers for correspondent loans, this new channel is still in its infancy. This is why MSR prices did not rebound as quickly as MBS prices (thank you, Fed) or even non-QM (thank you, investors).

But more recently MSR prices have been increasing, as the difficulties and uncertainties have resolved and clarified:

• Forbearance seems to have peaked and is in a slight decline. Although there are still risks of spikes up in the forbearance rate if there is a “second wave” or gov’t assistance dries up, we have not seen mortgage delinquency rates exceeding 20% as some models were anticipating.
• Some hedge fund and private equity money have been able to overcome some of the barriers to entry, through funding of new co-issue buyers and/or excess transactions
• New co-issue buyers have been approved by Fannie and Freddie
• Alternatives such as BAM Marketplace continue to grow
• Finally, most importantly, the traditional aggregator buyers of correspondent loans, as well as the usual co-issue buyers, have returned to the market.

All this increase in demand for MSR helped the price of MSRs (and correspondent SRPs) to increase towards the end of the summer and early fall. But we are still not back to pre-COVID levels.

As an estimate, correspondent conventional implied MSR prices are current about 75-85% of their pre COVID levels. Government is about 60% of pre-COVID levels. To contrast, early to mid-summer pricing were about half these current levels.

For Co-issue, the current conventional bid is about 75-80% of the way back to pre-COVID levels, with Ginnie Mae are about 65-75% of pre-COVID levels.

But to be honest, this trend is changing week to week as the market corrects. So perhaps these estimates may have to be revised by the time this letter is released!

Interestingly, the bulk market appears to be softer than the co-issue market, whereas normally the co-issue market trails the bulk market. Co-issue bidders usually expect a higher return because they are offering a fixed pricing grid for a fixed period of time, without knowing exactly what the seller will deliver to them. This uncertainty is costly to the buyer, so they usual expect higher returns.

But currently bulk sales, with many pre COVID loans which may or may not be subject to forbearance (co-issue loans have the advantage of pre-closing VOEs, so less likely to experience forbearance), which are very much in the money with respect to prepayment risk, thus presenting more uncertainty than the usual bulk market.

Like this post? Read Phil Laren’s Forbearance in 2020: Challenges & Recommendations for insight on forbearance this year. 

Future Expectations of the MSR Market

With all these Seller/Servicers holding more MSRs than planned, the question of when/if to sell is natural. The answer depends on:

• Will the market return any time soon to pre-COVID levels?
• Could it perhaps go higher?

Like all markets, especially illiquid ones like MSRs, stability breeds interest, and interest means more buyers and better prices. So a cure for the virus, a return to a strong economy and the MSR market should get stronger. Furthermore, a stable economy creates the expectation that the Fed will step off the gas pedal, and rates may increase. So there are a number of industry veterans who have observed that since mortgage rates are at their lowest levels ever, these loans will be around forever.

I am not one of those people. There is enough evidence, both internationally with respect to sovereign debt and in our current market with our historically wide primary secondary spreads, to think that we may not be at the bottom of the interest rate cycle.

Hiding from the Inevitable

In fact, aside from the direction of interest rates, I have other long-term concerns regarding MSRs. I believe the continuing evolution of the mortgage origination process is having a significant impact on the value of MSRs, as it relates to the ease and cost efficiencies of refinance, and, for that matter, ease of completing a purchase transaction. A major force effecting the value of MSRs is the likelihood of the loan prepaying. More likelihood means the servicing asset will not be around a long time, and high prepayments are one of the most significant factors impacting MSR value decline, as well as potential decline when rates are higher. Technology facilitating refis and purchases means prepays will be faster.

This does not mean MSR values are in a continuous state of decline. In fact, I believe having the customer connection and the ability to reach out to a borrower for a potential refi will be an important factor in increasing MSR value in the future and an important reason to service the borrower.  I expect MSRs to take a greater share of their value from the ability to market to a borrower. At the same time, that will reduce the market risk of lower rates driving prepayments and MSR value downward.

And that will improve value, both from a static and stochastic methodology…but that analysis is for another letter.

Meantime, stay well and stay safe!