At the recent Mortgage Bankers Association annual convention, lenders warned that mortgage servicing rights are a key threat facing the industry.

In his presentation, Marito Domingo, executive vice president at Washington Mutual, made a case for a change in the primary and secondary markets to address this issue.

"Lenders are holding on to more servicing than needed," Domingo said. He added that lenders, as a result, are holding interest-only investment risk that should ideally be left to more sophisticated investors, such as buyers of mortgage-backeds.

However, with the base servicing fee in the current environment relatively high - as unit costs have gone down with the advanced technology and scale - the margin between the revenue and expenses has increased the absolute value of mortgage servicing rights. Thus, servicers have had to expand their roles to become IO investors.

This has further stratified the industry into capital "have" and "have-nots," as the bigger players, such as Washington Mutual, Countrywide Home Loans Inc., CitiMortgage, Bank of America, Wells Fargo and Chase would obviously have a strategic advantage. On the other hand, smaller players that are both lenders and servicers might choose to become merely lenders, maintaining a correspondent relationship with the bigger lenders. In this case, smaller lenders would still originate the loan but would sell the servicing part of the business to the stronger players. These players also do not have as much access to the equity and capital markets.

Managing the MSR risk

Market participants should work toward a mechanism to lessen the amount of servicing that is capitalized as well as try to bring the mortgage lending business back to being cash-neutral, WaMu's Domingo said.

He proposed three methods to accomplish these goals - to institute prepayment penalties in return for "advancing closing costs," to add closing-cost advances to principal balance and to sell "excess" servicing to MBS buysiders.

Instituting prepayment penalties would not cut into the profitability of lenders if an industry standard is adopted, said Tony Ramirez, a vice president at WaMu. And in any case, the primary driver of mortgage refinancing activity is interest rates or home price appreciation, and not whether prepay penalties are present. "Ultimately, the customer has to decide whether to incur the prepayment penalty to lock in the lower rate," said Ramirez. "It's a fair tradeoff that the customer can make."

It is important to strike a balance by charging the appropriate prepayment penalty corresponding to the risk of advancing origination costs that are collected over time. Another option would be to advance closing costs, making it part

of the principal.

In terms of selling "excess servicing" to mortgage-backed investors, this involves trading mortgage-backeds in quarter coupons, or even one-eighth coupons, allowing originators to sell their "excess" servicing and book cash gains.

A report written by UBS early this year, when originators started selling FNMAs with 5.75% coupons, explained the reasons why quarter coupons were being created. They gave the example of an originator who originated a mortgage with a gross WAC of 6.0 or 6.125. "By packaging this loan in a 5.75% pool, the originator essentially sells off 25 basis points more servicing than would be possible in a 5.5% pool," wrote analysts.

Ramirez explains that mortgage servicing rights could be bifurcated into the base servicing fee, which covers the cost of operation, and the ongoing servicing income that looks like an interest-only investment. WaMu's Ramirez said that MBS investors are better equipped to hedge this interest-only risk.

"Typically, one of the challenges is to hedge MSRs to conform to

FAS 133," said Ramirez. "I don't think we are best equipped as an industry to do that, especially the smaller players."

Aside from this, creating a market for one-quarter or one-eighth coupons would be beneficial to investors because this would result in a tighter WAC dispersion. "By virtue of issuing more discrete increments of MBS coupons, you are, in effect, achieving that same effect of reducing the range of note rates that go into that coupon," said Ramirez. "This would be better for the investors because now they have a tighter population of loans that they can have more certainty with in terms of prepayment speeds."

However, the problem with trading MBS in quarter coupons or one-eighth coupons is the lack of liquidity. In the same UBS report, analysts wrote, "When investors buy Agency MBS passthroughs, they are entitled to liquidity for the long run, which they won't find in the 5.75% coupon. It's a bad deal; the 5.75% coupon is priced as rich as it is likely to get." Analysts added that this coupon might make sense in CMO form because of the good bid for the IO. In this case, UBS said that investors should simply realize that these transactions are simply high WAC 5.5% deals "in drag."

Because of the lack of liquidity for quarter coupons in the secondary market, WaMu has opted to offset some of the MSR risk by selling whole loans with base servicing only. In this case, if the note rate to investors was 6%, the firm keeps 25 basis points as the base servicing and sells the note rate at 5 3/4. This is a case where Freddie and Fannie do not get involve, so there's no guarantee fee necessary; however, there is a minimum standard for credit that the mortgages should have.

"The pricing reflects that there is no guarantee fee," said Ramirez. "It's being priced accordingly. The good news for us is that we're able to sell 5 3/4 of a note rate by selling through the whole loan market. Whereas in the case of securitization, we would have to take that same 6%, keep 25 basis points as the base servicing fee, and then pay Fannie Mae a guarantee fee, which leaves some basis points left over before securitizing the 5.5% coupon. So we end up taking that residual MSR risk." Ramirez added that there are certainly programs that are on their way which are used as alternatives to trading the quarter coupon in the secondary market. These programs have had very strong results.

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