Summary
Most large banks hedge their MSR positions creating an offset that would show up in scenario analysis, although Government intervention is hard to measure. The Natural Hedge needs to be considered.
Analysis
Mortgage Servicing Rights or MSR's are essentially an IO with a business component to them. The business is collecting and processing payments from borrowers. Historically, the performance of the MSR payoff have been highly correlated with changes in interest rates. This is still essentially true and can be hedged effectively with long mortgages positions, receiving fixed in interest rate swaps or buying call options.
The decline of housing prices have created a "buffer" for servicers to retain more customers than most prepayment/refinance models would predict. In other words, prior to 2009 prepayments have been much slower than modeled. This estimation error would create an extension of the MSR beyond the modeled period creating an economic gain for the servicer. This gain would typically be realized in a higher yield over time.
The largest risk for an MSR portfolio is the impact of new government programs and how they will impact them. Given the MSR goes away when the mortgages pays-in-full could cause MSR values to decline more than expected. There is an offset though, these same mortgage companies should be able to generate higher gain-on-sale for the new mortgages that are being originated in these government programs. The new value of an MSR for an at or below market rate mortgage should exceed the value written-off.
In summary, MSR portfolios should be viewed in context of the overall mortgage platform, e.g. the "Natural Hedge" is alive and well.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
