For decades, mortgage servicers handling Fannie Mae and Freddie Mac loans have been paid a set minimum rate for every dollar of performing loans they tend.
That rate, currently a quarter of 1%, is the foundation for the industry's compensation structure, hedging and accounting, and the right to collect it makes up a hefty portion of the largest banks' balance sheets. But like other institutionalized elements of the business, the 25-basis-point fee may soon be in for an overhaul.
While details are scarce, industry sources say they expect the GSEs to soon float a significant proposal. While the fee structure could be altered in any number of ways, it's likely that the changes would reduce the value of servicing rights, which most sizable banks account for as a capitalized asset.
That in turn could affect how banks hedge, account for and ultimately service their portfolios, upending how a big chunk of the mortgage industry does business.
Fannie, Freddie and their conservator, the Federal Housing Finance Agency, all declined requests to speak for this story. So did the top three servicers, Bank of America Corp., Wells Fargo, and JPMorgan Chase. Privately, several industry participants said they expected the GSEs would push to lower the fees.
Another, Dave Stephens of United Capital Markets, has been warning colleagues that the GSEs might seek to eliminate percentage-based servicing fees entirely.
"We need to make certain that this proposal is aired in an open process that considers the best interests of a wide constituency," Stephens, who hedges small to midsize banks' servicing portfolios, wrote in December.
Servicing fees date to the 1960s. Originally 50 basis points per loan, the fees were intended to cover the cost of servicing, plus a profit to align servicer and investor interests. That rewarded servicers for keeping mortgage pools performing. And because each loan would produce a steady stream of income over its life, the thinking went, servicers were less likely to "churn" their portfolios by rapidly refinancing borrowers to the detriment of mortgage bondholders.
While servicing fees were intended to be generous, they have come to make up an increasingly large portion of a mortgage's overall profitability as efficiencies lowered costs and the average loan size grew. When capitalized and held at fair value, that built-in profit creates mortgage servicing rights, a fairly volatile asset that rises and falls in value depending on borrower prepayment speeds, which in turn depend on movements in interest rates.
The asset had drawbacks. For small to midsize institutions that retained the servicing on government-backed loans they wrote, the accumulating value of the rights can rapidly outstrip their balance sheets' capacity. Moreover, hedging MSRs has long been a strain, particularly for banks without much capital markets experience.
"There have been a lot of concerns about the basis structures forever," said Jeff Naimon of the law firm BuckleySandler.
Early in the last decade, Countrywide (now a part of BofA) fought to have servicing fees cut in half. In 2006 a number of banks pursued an alternative to the minimum servicing fee that would substitute a requirement to hold some of the resulting securities for the MSRs. The idea was "Let's just force the servicer to hold a piece of the pass-through they create," said Mark Friedenthal, a former Citigroup executive who led the effort and now runs a private portfolio management business, Friedenthal Financial.
The last few years of tumult in the mortgage market have brought additional grievances. Consumer advocates (and, increasingly, the GSEs) have become concerned that the current pay structure provides too little incentive for servicers to invest in modifying loans and other nonforeclosure solutions.
And, perhaps most important, updated rules from the Basel Committee on Banking Supervision will limit "intangible" assets like MSRs to 10% of Tier 1 capital, a more stringent level than U.S. regulators' current 50% cap. For the country's biggest servicers, some of which are near the proposed cap at a time when MSR values are deeply depressed, lower servicing fees — and thus lower MSR valuations — might take off some of the pressure.
Any effort to change the servicing fee structure would have to pass muster with investors and ratings agencies, which would need to be convinced that servicers would not churn their portfolios — and that enough value would be embedded in a servicing portfolio to ensure it could be transferred in the event of a servicer's failure.
Not everyone favors an overhaul. Brian Chappelle, a partner at the consulting firm Potomac Partners, said the servicing fee structures have worked better over the years than they've received credit for.
"I don't think you should restructure the whole servicing industry because you've been overwhelmed by poor origination," he said.
Naimon also worried that any abrupt change could cause as many problems as it fixed. "While the basis-point system isn't so great," he said, "it may be like democracy: the worst system aside from everything else."