Evolution of the Mortgage Servicing Market Since 1998: Report to the Congress on the Effect of Capital Rules on Mortgage Servicing Assets
This report includes the results of the study conducted by the federal banking agencies and NCUA and incorporates analysis on MSAs that was undertaken by the federal banking agencies before the issuance in 2013 of the federal banking agencies’ revised capital rule (revised capital rule) and by NCUA before the issuance in 2015 of the NCUA capital requirements.
While servicing is inherent in all mortgage loans, a mortgage servicing right (MSR) is created only when the act of servicing is contractually separated from the underlying loan. A firm, for example, that originates a mortgage, sells it to a third party, and retains the servicing would report an MSA on its balance sheet, if certain conditions are met.3 That MSA therefore would be subject to a capital requirement. Conversely, a firm would not report an MSA if the firm originates a mortgage, holds the mortgage on its balance sheet, and performs the servicing.
This study examines the evolution of the mortgage servicing market during the past 20 years and concludes that the market has been shaped by a variety of factors. These factors include
- changes in interest rates;
- sharp fluctuations in housing prices, and the corresponding changes in mortgage debt and surge in nonperforming loans;
- shifts in the desirability of securitizing mortgages versus holding them in portfolio; and
- regulatory, tax, and accounting changes related to mortgage servicing.
The report describes this historical evolution of mortgage servicing by examining the effects of these factors on the MSA holdings of banking institutions and federally insured credit unions. Further, the study analyzes historical changes in the ratio of MSAs to capital, and how changes in this ratio have varied across different types of banking institutions and federally insured credit unions.
In evaluating the characteristics of MSAs, the study identifies two key risks to a firm’s mortgage servicing activities: business risk and valuation risk. Business risk refers to idiosyncratic risks related to a firm’s mortgage servicing activities and can include legal, compliance, and reputational risk. Valuation risk refers to risks inherent in a firm’s ability to accurately estimate a value for its MSAs and is driven mainly by interest rate risk but is also affected by default risk. The study also finds that MSA valuations are subject to forecast uncertainty that can be exacerbated under adverse financial conditions and result in liquidity strains.
Determining the fair value of an MSA can be difficult because MSAs do not trade in an active, open market with readily available and observable prices. This valuation difficulty is also in part because MSAs tend not to be homogenous assets, as they differ by loan size, interest rates, servicing fees, maturity, credit quality, and the entity, if any, that provides a credit guarantee on the underlying loan, among other characteristics. Thus, a firm is generally not able to value its MSAs based on sales alone, as those sales are unlikely to be sufficiently comparable to the MSAs being valued. As shown by the report, to estimate the value of MSAs, banking institutions use financial models, which estimate the present value of net future cash flows associated with servicing activities, and compare and benchmark their estimate with several market-based sources.
Key Conclusions of the Study
- MSA valuations are inherently subjective and subject to uncertainty, as they rely on assessments of future economic variables. This reliance can lead to variance in MSA valuations across firms. Moreover, adverse financial conditions may cause liquidity strains for firms seeking to sell or transfer their MSAs.
- Between 2007 and 2015, Material Loss Reviews (MLRs) identified MSAs as a factor contributing to the failure of four insured depository institutions; there is evidence that other failed institutions experienced some degree of problems with their MSAs.
- Excluding MSAs transferred by the FDIC as receiver pursuant to a whole bank purchase and assumption transaction, since 2007 there were 36 failed banks that held MSAs and the MSAs at 31 of those failed banks had no net value in a sale transaction.
- The federal banking agencies have long limited the inclusion of MSAs and other intangible assets in regulatory capital because of the high level of uncertainty regarding the ability of banking institutions to realize value from these assets, especially under adverse financial conditions.4
- MSAs represent a small share of both the aggregate amount of total bank assets and the aggregate amount of common equity tier 1 (CET1) capital.5 From 1998 to 2015, the highest levels that MSAs ever reached as a percentage of assets and MSAs as a percentage of CET1 capital were 0.7 percent and 9 percent, respectively.6 By the fourth quarter of 2015, these levels were lower, at 0.25 percent as a percentage of assets and 2.8 percent as a percentage of CET1 capital.7
- Most banks in the United States–around 83 percent–do not hold any MSAs.8
- Nonbank servicers have gained significant market share since 2011. The gain in nonbank market share of servicing appears largely attributable to large-bank sales of crisis-era legacy servicing portfolios and an increase in mortgage origination activity among nonbanks.
- Banking institutions continue to service most residential mortgage loans that they sell to Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs).
- The mortgage servicing market remains quite competitive as it is not highly concentrated, as gauged by standard measures of market concentration.
- Although MSAs have become a smaller share of banking sector assets in the aggregate, the number of banks that held MSAs increased during the 1998 to 2015 period.9 The increase stems almost entirely from small banks (total assets less than $10 billion), which, for example, held less than 2 percent of total MSAs in 2009 as compared to 8 percent in 2015. Most banks with MSAs have small holdings and would not exceed the threshold that would trigger a capital deduction under the revised capital rule.
- Assuming fully phased-in implementation of the revised capital rule, the vast majority of banking institutions would be able to satisfy minimum risk-based capital requirements without any change to their mortgage servicing activities or portfolios.
- A pullback of aggregator banking institutions (i.e., banking institutions that purchase mortgage loans and servicing rights from other firms) from the MSA market could have effects on MSA pricing and liquidity; conversely, the effects of stronger bank capital requirements and mortgage reforms may make the residential mortgage market and its bank lenders more resilient and a recurrence of crisis-era problems less likely.
- The capital requirements that apply to banking institutions would not necessarily be appropriate for nonbank servicers. If the capital requirements applicable to banking institutions were hypothetically applied to nonbanks, the impact on the nonbank servicing institutions would vary according to their business model. Real estate investment trust (REIT)-type servicers, which represent a small share of the nonbank servicing market, would be minimally affected because they hold significant portfolios of assets other than MSAs. Nonbank mortgage servicers with significant holdings of MSAs relative to their capital and with limited or no business diversification would likely not be able to satisfy minimum capital requirements on a stand-alone basis unless they took remedial actions (e.g., changed their business models, increased their capital ratios).
The past several years have demonstrated that the mortgage servicing market continues to evolve. While the federal banking agencies and NCUA do not recommend any additional statutory or regulatory actions at this time, the federal banking agencies and NCUA will continue to monitor developments in mortgage servicing industry standards and practices, and will exercise their regulatory and supervisory authorities, as appropriate, to pursue their respective statutory mandates, including ensuring the safety and soundness of depository institutions and the stability of the U.S. financial system.
Full report below…
Report to the Congress on the Effect of Capital Rules on Mortgage Servicing Assets