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MSRs – Buy, Sell or Hold?

September, 2016

Clients and Friends,

2016 to date has featured yet another significant bond market rally, accompanied by rapid prepayment speeds and painful mark-downs to the carrying value of MSRs. However, for many companies, this period has also been punctuated by robust origination volumes with solid profit margins. Many servicers we know are also becoming quite successful with recapture and some of the largest entities are reaping the benefit of MSR hedging programs. We frequently remind folks that the fair value accounting mark-downs of MSRs are non-cash entries, and work both ways – when rates rise MSRs are marked back up.

Liquidity remains an on-going issue for non-bank seller/servicers, particularly in the GNMA MSR space, where very few MSR lenders are willing to take the unlimited risk implied by language in the GNMA acknowledgement agreement. Rapid prepayment speed assumptionsand higher yield requirements from wary buyers have resulted in bulk market bids that fall well below book values, and therefore selling GMNA MSRs for liquidity has been a poor alternative in 2016.We have no quarrel with flow sales but don’t forget to factor in the lost benefit of the tax wedge when determining best execution. For larger GNMA servicers, alternative “financing” options may be available.

Even if traditional MSR financing is fully utilized, it typically comes with an advance rate of not more than 60% of fair value, leaving a material haircut to be funded by the servicer. In addition, we are observing more and more large non-bank servicers where the MSR asset is approaching or even exceeds net worth. This indicates the need to add to capital, likely best accomplished by issuing preferred shares or subordinated debt. Such an increase in the capital base should lead to the ability to add more relatively cheap MSR financing, permitting those that wish to do so to continue aggressively retaining MSRs. Therefore, while appearing to be expensive at first blush, if used properly the mezzanine financing can be quite accretive and certainly is cheaper than selling a minority equity stake.

With bulk bids at disappointing levels and other means of extracting liquidity available but limited, what is the correct assessment of MSR retention/ownership at this juncture? While no one can predict future interest rate movements, we continue to believe that MSRs represent a good value proposition. If rates rise, multiple expansion will occur. Even if rates don’t rise, the tax wedge combined with strong positive cash flows and improved customer retention combine to make retaining MSRs very attractive for firms that can figure out how to solve the liquidity challenge associated with sacrificing the SRPs on the loan sales.

If rates plummet to new all-time lows, then certainly MSRs are vulnerable to more mark-to-market pain, so be sure you are geared up for recapture, and if your portfolio is at 2X or more of annual production volume, take a hard look at adding some hedge protection. But keep in mind that MSR valuations are typically based on static interest rate assumptions, so only if the elevated prepayment speeds in recent MTMs become a reality over many years will the real value of the net cash flows be diminished as predicted by the valuation models. In other words, you will enjoy strong positive cash flow from recent vintage quality MSRs regardless of what the MTM requires to apply fair value accounting.

At Morvest Capital, our principal focus is on helping clients deal effectively with MSR ownership and associated liquidity issues. We have successfully assisted many clients with MSR financing. We have been successful with MSR auctions, private strategic MSR sales,EBO trades and other creative structures to extract liquidity from MSRs. Our MSR valuation services are performed using state-of-the -art tools and unmatched experience. We welcome the opportunity to visit with you on these subjects:

David Fleig, CEO 281-980-0757; dfleig@morvestcap.com

Chris Negri, Sales 303-918-9596; cnegri@morvestcap.com

John Sullivan, EVP, Valuation Services 972-315-0126; jsullivan@morvestcap.com

 

This entry was posted in Uncategorized on September 30, 2016

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