The last interest-rate decline was not kind to owners of mortgage servicing rights (MSR). As interest rates dropped, prepay speeds soared and values plummeted.
As illustrated in Figure 1, all of the major servicers experienced significant declines in servicing values over this period, according to the 10-Qand 10-K filings of these public companies.
[FIGURE 1 OMITTED]
We are now seemingly entering a period of rising rates. This is a time when the servicing asset really proves its worth. It is also the time to prepare for the next rate downturn.
Discount rates (yield requirements) in our industry have always been "sticky" as rates rise. As mortgage rates rise, discount rates increase--hut nowhere near enough to take into consideration the rapidly growing risk that rates will eventually come down once again. The yield that we require needs to increase appreciably as rates rise to compensate for this increasing payoff risk.
The two largest drivers of servicing values are prepayment speeds and discount rates. There is always a great deal of attention focused on prepay speed projection methodology, but much less on the discount rate.
The discount rate should reflect the return we demand on this investment. The rate currently used is often either subjective or based on rudimentary rubrics such as an x spread over the 10-year Treasury. A more logical approach to deriving this rate will not only make it more defensible to managers, auditors and regulators, but can also be constructed to prevent large write-downs in the next interest-rate decline.
As with any other investment, the discount rate should reflect the returns we could receive on other alternative investments plus or minus increments for the various risk elements unique to the servicing asset. In my opinion, the basis for the discount rate should be the mortgage rate, not the 10-year Treasury. Mortgage rates are more easily tailored to the characteristics of the servicing portfolio (e.g., 30-year, 15-year, 5/1 adjustable-rate mortgage [ARM], etc.), are readily discoverable and already reflect many of the risks inherent in the servicing asset.
The mortgage rate, however, does not exactly reflect all of the risk dynamics of the servicing asset. For instance, servicing has additional operational risks and is a less liquid asset. It also could be argued that, in most cases, its credit risk is less than the underlying mortgage (absent repurchase risk). It has a similar maturity risk to the underlying mortgage but, because of its negative convexity, has a much greater volatility of return as expected maturity ebbs and flows. That is, when rates drop and prepay speeds increase, the mortgage investors at least gets their investment back (more or less), while the servicing investors' cash flows simply stop.
Given today's somewhat limited market for servicing, it appears that the current spread over mortgage rates for newly originated 30-year, fixed-rate, agency servicing approximates 450 basis points. This would put today's base discount rate in the 9 percent to 9.5 percent range. While this spread needs to be tested regularly, it should be a fairly constant function throughout an interest-rate cycle. …