Lower single-family mortgage servicing fees: legitimate worry or tempest in a teapot?

MOODY'S INVESTORS SERVICE, NEW York, expects that any potential decreases to single-family servicing fees typically earned by mortgage servicers will not have credit ratings implications for mortgage banks, commercial banks or the government-sponsored enterprises (GSEs). However, a reduction

The credit profile of certain firms (e.g., originators and GSEs) could be positively or negatively impacted as a result of a reduction in servicing fees, but the degree of such impacts is not expected to be that significant, and it is unlikely to result in credit rating actions. However, over the long term, the reduction in interest-rate risk and capital exposures borne by mortgage servicers, stemming from their investment in mortgage servicing rights, would be a plus for that sector.

This column describes the rationale for lower servicing fees, as well as the potential benefits and costs for the various constituencies.

Mortgage servicing fee reduction: What's being considered and why

Fannie Mae and Freddie Mac (both are rated Aaa for their senior long-term debt, and have bank financial strength ratings of B-plus and A-minus, respectively), the two GSEs that dominate the secondary single-family housing mortgage market in the United States, and whose policies and practices affect a range of mortgage market behavior, have been considering a reduction in single-family mortgage servicing fees from the current industry-standard 25 basis points to perhaps 12.5 basis points.

GSE servicing fees are based on a percentage of the loan principal balance. Servicing fees are incorporated into mortgage rates when homebuyers take out loans. Lenders collect the fees through homeowners' monthly loan payments. The current standard servicing fee was established nearly 20 years ago, and took on greater importance when accounting rules changed in the 1990s with the introduction of FAS 125 (FAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," was superseded by FAS 140). The cash flows used to value servicing fees are based on the "contractually specified servicing fee," which has been interpreted by the mortgage industry as the standard servicing fee.

One major effect of a reduction of the mortgage servicing fee would be a decrease in the size of mortgage servicing rights (MSRs) now recognized on a mortgage servicer's balance sheet. The idea is that a reduction in MSRs would likely, in turn, reduce the potentially sharp swings in the value of MSRs due to interest-rate risk exposures, thereby reducing servicers' earnings volatility. Also, MSRs are "capital hungry"--a reduction in them would reduce servicers' effective leverage.

Under accounting rules, mortgage originators recognize a separate servicing asset upon the securitization or sale of mortgages, servicing-retained. In effect, at origination two assets are created: 1) a debt instrument and 2) a series of cash flows retained by the servicer of the mortgage representing future fees for collecting and disbursing the monthly interest payments to the mortgage investors, collecting and paying property taxes, insurance and the like. This servicing asset represents the present value of net future cash flows that will accrue to the servicer of the mortgage over the life of the loan.

Examples of cash inflows are servicing fees, late-payment charges and float income on escrow balances; while examples of cash outflows include servicing costs, foreclosure costs and advance costs. The projected cash inflows and outflows used to derive the value of the servicing asset are based on numerous assumptions, including future interest rates, prepayment speeds of the underlying mortgages, and delinquencies. These assumptions are reexamined each reporting period over the life of the underlying mortgages. Depending on the results of these reexaminations, the value of the servicing asset could increase or decrease, perhaps materially.

An impairment charge--a reduction in the carrying value of the MSR, with a corresponding reduction to income--is incurred if the servicing asset's fair value is below its book value. The servicing asset may also be written up in value, but only to its original cost basis. This volatility, as well as asymmetrical accounting (servicing assets can be written down to $0, but only up to original cost) make it difficult to effectively hedge MSRs, and require a greater amount of capital to support the volatility. These are key risk issues for mortgage servicers.

Let's now examine how the various participants in the single-family mortgage market could be affected by a change in servicing fees, as well as the impact on their credit ratings.

Mortgage originators/servicers

From the originators'/servicers' perspective, there are two opposing mindsets: One favors reducing servicing fees; the other is against it. The originators/servicers in favor of the reduction argue that the economics of origination/servicing would remain whether the servicing fee is 25 basis points or 12.5 basis points. Why? First, the mortgage originator originates both parts--debt instrument and servicing fee stream--so if less value is ascribed to the one, more goes to the other. In addition, significant revenue can still be derived from float, late fees and other ancillary servicing-related income, along with potentially lucrative cross-selling opportunities.

Furthermore, they feel that it is the originator/servicer's franchise and operational infrastructure that controls the economics of mortgage servicing, not the fee being charged: If you can reduce your per-mortgage servicing costs, you will earn more income. The proposed reduction in servicing fee is important to certain servicers because it monetizes the servicing strip upfront rather than capitalizing it on the balance sheet in the form of an MSR asset. This frees capital, reduces the costs and difficulty involved with hedging an MSR asset, reduces the accounting risk and reduces the notorious MSR-related earnings volatility that has plagued so many servicers--a credit positive in Moody's view.

On the other hand, some servicers, especially those with diversified business models that have more limited capital concerns (read: commercial banks and thrifts) than stand-alone mortgage banks, are advantaged under the current mortgage servicing fee regime and are less interested in change. Today's servicing fee structure provides a potentially important competitive advantage to these servicers, as their MSR asset tends to be a smaller part of their balance sheet, thus creating less risk relating to the hedging and accounting costs and risks, and less aggregate earnings volatility.

Should the servicing fee be reduced, it would likely be a net plus for the nonbank servicers--which are comparatively more vulnerable to the value and hedging risks of MSRs--and a slight credit plus, or neutral factor, for large, diversified financial institutions. However, Moody's believes that a reduction in the servicing fee will bring price competition, which will in turn negatively affect the weaker servicers in the industry.

The GSEs

In considering a reduction to their servicing fees, the GSEs are responding to the desires of many mortgage servicers. A lower servicing fee bestows limited benefits to Fannie Mae and Freddie Mac, and at best is a neutral credit event for them.

Fannie Mae and Freddie Mac established the standard servicing fee, at least partly, to align the interests of mortgage servicers with those of mortgage security investors--including, especially, themselves. The capitalization and size of servicing fees, it has been argued, provide the servicer with a strong economic incentive to ensure that servicing is performed according to the GSE's standards. If they fail to perform properly, Fannie Mae and Freddie Mac can seize and transfer the servicing--a real economic loss for the servicer. Some have argued that a reduction in servicing fees would diminish the GSEs' ability to regulate servicers.

Moody's believes that even a reduced servicing fee would still provide adequate incentive for servicers to perform their tasks well. In addition, Moody's notes that forced transfers of mortgage servicing portfolios are rare. While this fact supports the notion that the current fees ensure strong incentives for lenders to comply with servicing requirements, it also indicates that a moderate reduction in servicing fees would still provide appropriate servicer incentives.

Moody's believes the GSEs' credit profile would be negatively impacted if the result of lower servicing fees was to lessen their control over servicers, or create less liquidity in their mortgage securities. We do not believe these are going to happen.

Mortgage investors

Mortgage investors universally view negatively a reduction of mortgage servicing fees. Investors' concerns regarding a reduction in servicing fees include questioning whether mortgage prepayment characteristics will change. The idea here is that the current servicing fees require mortgage originators to maintain "skin in the game." The mortgage servicer will realize less income over the life of the security should prepayments increase above the original forecast when the standard servicing fee is 25 basis points.

Investors are concerned that a lower servicing fee may provide incentives for mortgage servicers to "cherry pick" and securitize loans with higher-than-normal prepayments. While this shift in prepayment speeds might not come to pass, the investors' concern itself is a worry to the GSEs. As a result, Moody's would expect the GSEs to move cautiously with any changes to servicing fees, so as not to cause market disruptions.

Brian Harris is vice president-senior analyst, and Philip M. Kibel and Sean Jones are senior vice presidents and analysts with the real estate finance and banking teams at Moody's Investors Service, New York.