Week In Review: Mortgage servicing marks look aggressive.

Last week was relatively data-light, which is typical for the week after the jobs report. The main events were an interview that Jerome Powell did with David Rubenstein and consumer sentiment from the University of Michigan. Jerome Powell discussed the strong jobs report and stressed that the job market remains super-tight although he acknowledged that the the disinflationary process has begun. He said that we should expect the Fed to remain restrictive for some time and that removing inflation is not likely to be easy and painless. He also assuaged the market about the Fed selling some of its portfolio of mortgage backed securities saying that selling is not something the Fed is actively considering.

The University of Michigan Consumer Sentiment Survey showed that sentiment remains low, and inflation is a big driver of that. The Fed pays attention to inflationary expectations since once inflationary expectations become built into the economy, it becomes a self-reinforcing process. Inflationary expectations for the next year rose from 3.9% to 4.2%, although the long-term inflationary expectations remained at 2.9%. The Fed wants to see inflationary expectations right around the Fed’s 2% inflation target.

During the past week we saw earnings reports from several mortgage REITs. The sector was beaten up as badly as mortgage originators were in 2022. The thing that stood out to me was servicing valuations. We are seeing aggressive servicing valuations which are probably unsustainable.

First, a primer on mortgage servicing, since some readers might not be super familiar with it. Mortgage servicers handle the administrative tasks of the mortgage on behalf of the lender. If the loan gets put into a mortgage-backed security the investor in that security is the lender.

The servicer sends out the monthly bills, collects payments, sends the principal and interest to the lender (or MBS holder), ensures that property taxes are paid, that homeowner’s insurance is up to date, and works with the borrower if they start missing payments. If the borrower misses payments, the servicer will have to advance (in other words reach into their own pockets) to pay the principal and interest to the lender which will get recouped at some later time. For compensation, the servicer gets paid usually 0.25% of the mortgage’s outstanding balance. If the borrower owes $400,000 then the servicer gets $1,000 per year. The right to perform this service is worth something, and the asset gets capitalized on the balance sheet as an asset.

The value of that servicing portfolio is based on a complex model which is based on all sorts of assumptions about prepayment speeds and delinquencies as well as short term interest rates. As a general rule, servicing has usually traded around 4x. In other words, if the servicing fee is 0.25%, then the mortgage servicing right (MSR) on that $400,000 mortgage is $4,000. These valuations are highly sensitive to interest rate movements. When rates are falling servicing values fall, because people have an incentive to refinance, and there is the possibility that you only get that $1,000 fee for a short period of time. In a period of rising rates (like last year), they become worth more because investors can expect to receive that payment for longer.

Rising rates over the past year have made the refinance option deep “out of the money.” In 2020 and 2021 lots of people refinanced their mortgages and are paying rates around 3.5%. The incentive to refinance is largely gone, and the MBA’s Refinance Index is at 20 year lows. The only people refinancing their mortgage are doing it to extract home equity.

I took a look at where different mortgage REITs are valuing servicing at the end of the year, and it is pretty high. PennyMac Mortgage Investment Trust is valuing their servicing portfolio at 6.1x, which is pretty hefty. Interestingly, PennyMac Financial Services (different company, but obviously related) is valuing its servicing portfolio at 5.2x. The portfolios have similar note rates: Pennymac Mortgage has a 3.5% average note rate while PennyMac Financial has a 3.4% note rate. Differences could be based on average age, credit scores etc. That said, 6.1x is pretty much full value. I think valuations got that high during the residential real estate bubble, but at 6.1x, servicing valuations have nowhere to go but down.

Rithm Capital (basically New Rez and Caliber production) is valuing its servicing portfolio at 4.9x which is a bit more reasonable. Annaly Capital is valuing its servicing portfolio at 5.25x. Is servicing trading in the marketplace at these levels? It is possible, but unlikely. The supply and demand dynamics for mortgage servicing have changed, where originators with low cash are selling servicing in order to raise cash. I think typical bulk sales are going with multiples in the mid-4s.

If the US hits a recession next year, then servicing values will probably have to fall, especially if the Fed starts cutting rates. While the production from 2020 and 2021 might not prepay, loans originated in the past year probably will. Delinquencies will increase as well, and you know FHFA will pull out all the stops to prevent lenders from foreclosing. That will negatively affect servicing valuations. There is no way it cannot.

What if interest rates go back up? Even if that happens, prepayment speeds are pretty much as low as they can go. People won’t necessarily refinance, but they will move. At this point, servicing will have limited upside because the prepayment effect is completely played out.

Next year we will probably see increased tightening of MBS spreads, so I have to imagine that prepay assumptions could be low. Even if the 10 year goes nowehere, lower MBS spreads could mean rates in the low 5% area again, which then brings back the incentive for cash-out refinances.

I suspect this was the peak for mortgage servicing, and those stocks with aggressive servicing multiples might be taking writedowns next year.