As more and more statistics come out showing lower delinquency percentages and decreasing foreclosures, many mortgage bankers are asking themselves if they really need a default or “special” servicing operation. The passing of Dodd-Frank and the birth of the CFPB have dramatically changed the landscape of default servicing, particularly now that the new servicing standards are in effect and being strictly enforced. What many banks have come to realize is that the costs and risks associated with running a default servicing platform today are simply just not worth taking on in-house.
A bank’s core competence, in most cases, is its ability to measure risk and make intelligent loans to its customer base. However, today, an effectively run default servicing operation can draw excessive amounts of precious time, talent and capital away from a bank’s key lending efforts. Most banks’ troubled loan portfolios are shrinking yet cost structures are moving in the opposite direction. It can be a multi-million dollar undertaking to manage even small portfolios when you look at both the operational and compliance components necessary to establish the appropriate compliance regime and then to be able to stay current with ever-changing regulatory standards and government borrower relief programs. Policies and procedures must change, technology needs upgrades, more staff is needed to execute the new procedures and more managers are needed to monitor and administer the operation. At the same time, the penalties for missteps can be large and the mortgage industry is still struggling to truly understand what they will actually be.
It is also important to consider negative exposure for the brand. When the hard cases arise and foreclosure is a likely outcome, many banks are choosing not to fight those battles and face the potential negative headlines, and are placing that responsibility with another institution with a strong track record and deep experience handling the toughest cases. Many banks are saying they have enough headline risk and the reward of holding on to the servicing simply is not justified.
There are other financial reasons for banks to lose interest in servicing. It is well understood in the industry that mortgage servicing rights (MSRs) will receive weaker capital treatment under BASEL III. Specifically MSRs will cap out at being 10 percent of a bank’s common equity Tier 1 capital and any MSRs that are not deducted from a bank’s common equity Tier 1 ratio will move from being a 100 percent risk weighting to a much more punitive 250 percent risk weighting. The effect of losing this powerful capital ratio enhancement is certainly taking meaningful luster out of the MSR value proposition for banks relative to other assets.
A second and more immediate benefit to exiting servicing is the actual sale price of the MSRs (received at origination or after some degree seasoning), which are trading at a premium to historical levels given the low interest rate environment and the market’s rabid search for yield right now across the credit spectrum. Many bankers are addressing origination volume shortfalls by taking advantage of the strong investor demand for MSRs and their intrinsic interest rate hedge. MSRs are being bought into very leverage-friendly structures and investors continue to bid up the asset class. Bankers are also taking notice that they can offload costly servicing obligations by selling both performing and non-performing whole loans, which are each trading at high levels (as a percentage of UPB and property value), as well. For example, a June HUD non-performing loan sale resulted in most of the pools selling in the mid-high 70s as percentage of BPO (broker price opinion or essentially a quick sale property value). For many banks that represents a much more attractive resolution than managing the delinquent loans themselves over a long period of time. Instead they would much prefer to move on and allocate that capital in an asset more closely tied to their long-term growth plans.
Strategic human resource allocation, brand protection and maximization of capital in the midst of a hot MSR/whole loan market are all themes that are forcing bank executives to re-assess the optimal strategy for their servicing (particularly their default servicing) operations and the assets they manage. The mortgage sector can move quickly and then inch along quite slowly, so it is wise to constantly gauge where your business is headed relative to the market, enabling you to make the right decisions for your institution no matter what environment you face.
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