The issue of reducing minimum mortgage servicing fees to 12.5 basis points from 25 basis points is back in the spotlight again. After failing to gain full industry support - some servicers launched a marketing effort lobbying for this change over the summer of 2003 - analysts are suggesting that there is more of a market consensus for lower servicing fees.
"Although it is still going to be a challenge for the agencies to build an industry consensus on this issue, our impression is that there is much more momentum behind the effort this time with the majority of large servicers that we have spoken to supporting the change," noted Bear Stearns researchers in a recent report.
Sources theorized that with a reduction, all servicers would be given greater flexibility in determining the amount of servicing fees to retain, and therefore the investment needed to retain a customer relationship. The Bear Stearns report added that the proposed change in servicing fees is crucial to certain services since it monetizes the servicing strip up front versus capitalizing it on the balance sheet as a mortgage servicing rights asset. Analysts said that this frees up capital, limits the costs of hedging mortgage servicing rights and reduces mortgage servicing rights-related earnings volatility.
Without a change in the servicing fee requirement, institutions with deep capital would likely "win," said a source associated with a major servicer. Bear Stearns said that for capital constrained servicers the reduction in minimum servicing would have a significant effect on growth potential and their ability to position themselves within the market. It is not surprising therefore, added Bear, that those servicers with fewer capital constraints and a competitive advantage are less interested in the change.
While the lower required servicing fee might appeal to smaller servicers, the larger players would still retain significant competitive advantages, sources pointed out. With the lower servicing fee, economies of scale would become an even more important driver of value. Additionally, while the reduced fee would lessen the investment cost per unit, risk management expertise and minimizing cost of capital would continue to be important components of managing and valuing servicing.
Bear Stearns also noted that servicers now have other outlets to limit their exposure to the mortgage servicing rights asset such as the securitization of the excess servicing portfolio. The problem is that the execution from all these alternatives is inferior to that achieved in the TBA market, added analysts. Other sources said that most servicers now hedge their mortgage servicing rights risk exposure. But hedging programs still leave the servicer with basis exposure between the hedge and the servicing asset. Several programs have been used over the years to sell the servicing strip synthetically, but these programs have never achieved pricing levels that have made them broadly attractive.
One effect of reducing the servicing fee is shifting the risk to MBS investors. IO assets, such as mortgage servicing rights, could be more efficiently held by secondary market investors.
Reducing the minimum servicing fee has the potential to transfer some of the aggregate investment and volatility to the capital markets. However, whether or not the reduced fee will prove beneficial will likely be driven by how economically the fee can be transferred, and ultimately, the ability of the capital markets to more efficiently fund and manage the additional interest strip over time, sources said.
Bear Stearns said that investors should be alright with a reduced servicing fee in the TBA market so long as there are no statistically significant prepay differences between the minimum and standard servicing fee pools. However, investors are concerned about increased servicer solicitation of borrowers backing minimum servicing pools. Investors also worry about adverse selection - servicers pooling loans with the least desirable prepay characteristics into pools where the least amount of servicing is held.
Bear Stearns analysts counter that solicitation is not as much of an issue because of increased borrower efficiency in exercising the refinance option, diminishing solicitation efforts. However, analysts said adverse selection has bigger relevance in today's TBA market.
Servicers could not really target customers based on servicing fees because the customer ultimately holds this option. Agency guidelines also prohibit selective marketing. If everyone's servicing fee were 12.5 basis points, there would be no way to differentiate between customers. The biggest concern, a source said, is presumably "skin in the game." If a servicer, for instance, has less in the form of reduced servicing fee, solicitation would be more likely. However, if brokers have really no "skin in the game," why should servicers be at a competitive disadvantage in soliciting customers, he asked.
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