The Obama administration's white paper on housing finance reform might have been short on details on how the government plans to initiate housing finance reform.
However, it did highlight the more detailed discussion on alternatives for a new mortgage servicing compensation structure.
The white paper recommends instituting national standards for loan servicing. Loans should be serviced promptly and appropriately. It also called for reform of servicer compensation, an issue that the Federal Housing Finance Agency, the U.S. Department of Housing and Urban Development, and the GSEs are already working on.
The objective is to reform servicer compensation and better align incentives across servicers/guarantors. The agencies are looking to implement a new compensation structure that would encourage servicers to help borrowers avoid default or foreclosure when appropriate.
Regulators are also looking to improve treatment of lien priority and increase transparency about the presence of second liens.
Under the current system, servicers collect a minimum percentage of the loan balance annually, paid out of the interest stream. The servicers are compensated 25 basis points regardless of the loan. If they make loans to lesser-quality borrowers, they are also paid 25 basis points as they would if they were making loans to top-quality borrowers.
"What they have found is that, at the lower end the fee isn't enough, and at the higher end, the fee may be too much," a market analyst said. "The cost of servicing has gone up, both from the primary servicer and the special servicer sides of the equation."
Amherst Securities Group (ASG) analysts reported in a research report that the current 25-basis-point fee on a $250,000 loan garners $625 per year, or $53 per month for every loan.
The current system also creates a mortgage servicing right (MSR) asset that is difficult to manage. This will become even more difficult to handle for large banks under Basel III, which restricts valuing "intangible" assets such as mortgage servicing at above 10% of a bank's overall capital. Any MSR that is over that amount will be deducted from capital.
The current rules allow for 50% recognition factor before MSRs are deducted from capital. The Mortgage Bankers Association - in its October 21, 2010 comment letter to the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. - estimated that 56 banks, which account for 2/3 of the MSRs, already exceed this 10% limit.
"Holdings of large amounts of MSR assets are going to become significantly more expensive from a capital perspective under Basel III," Barclays Capital analysts said in a recent report. "As rates increase, this could leave some of the largest banks needing to raise capital, as increasing gains in MSRs will not count toward regulatory capital."
GSEs Lay Out Plans
The GSEs have laid out four possible changes to the 0.25% servicing fee that has long been the foundation of servicer pay, according to people with knowledge of the discussion.
The smallest step, cutting the fee in half, would reduce the size of mortgage servicing rights by more than 50%. This will alleviate the capital constraints that servicing-heavy banks now face from coming international capital standards, but leave the general structure of industry pay in place.
A second option is lowering the fee to a nominal amount, perhaps as low as three basis points -below even the largest servicers' cost of servicing a performing loan. This could be expected to wipe out MSRs entirely, removing the need to hedge and hold capital against them.
A third possibility is to completely scratch a basis-point servicing fee structure, replacing it with a per-loan stipend or payment for specific services rendered. This approach would mimic the already existing pay model for sub-servicers.
Finally, the GSEs raised the possibility of replacing a basis-point structure with an alternative minimum servicing fee, in which the servicer would have a 1% stake in the principal of the loan being serviced. Supported by some servicers in the second half of the last decade, this idea was put aside as the industry fell into disarray during the crisis.
Which Works Best?
Barclays analysts believe the servicing structure most likely to emerge is a fee-for-service model for nonperforming loans, which will reduce the minimum servicing fee for performing loans to a nominal amount - maybe around five to seven basis points.
ASG analysts agreed. The best way, they said, would be to lower the fees on performing and raise fees on nonperforming loans.
Under the current system, the cost of servicing nonperforming loans is by far more expensive than servicing performing loans. ASG analysts said a servicer they spoke with estimated the cost of servicing a performing loan at $4 per month, or $48 per year. By contrast, the costs associated with servicing a nonperforming loan were about $900 per year.
A fee-for-service-based approach for nonperforming loans, where the GSEs pay servicers a flat monthly fee to service a nonperforming loan, would ensure that the servicing of nonperforming loans was profitable and align servicer and guarantor incentives. "Paying a fee would make it a profitable business, and thus make it much easier for the GSEs to transfer servicing to a special servicer who could better service delinquent loans," explained Barclays analysts.
Under this option, the minimum servicing fee for performing loans would be reduced to zero and the servicer's compensation for servicing performing loans would consist solely of float and ancillary income. From a Basel III perspective, income would be deemed "adequate compensation" and thus would not need to be capitalized.
Less Skin in the Game for Servicers
However, this two-tier approach ultimately means less skin in the game for servicers.
Investors are concerned that the new models could mean that passthroughs with a higher coupon created today would prepay faster than those with a lower coupon, and accelerated prepayment speeds would result in a lower price for TBA collateral.
"So the key issue for regulators is to put some safeguards in place to satisfy investor concerns about adverse delivery for TBA," Barclays analysts said. "We think that they are likely very aware of these concerns and willing to meet investors half way."
One way to address investor concerns over the issue of faster prepays and problems with churning is to restrict servicer optionality by implementing safeguards that limit the flexibility of originators to choose which loans they would like to hold additional excess servicing on. This would be key to getting the collateral to be TBA eligible and not disrupting the market.
"A decrease in the minimum servicing fee should not give servicers more flexibility to retain the minimum servicing on pools that they think will be faster, and to retain more on pools they think will be slower," ASG analysts said. "A good outcome for all sides would be to couple a reduction in minimum servicing with some limitation on servicer flexibility."
Gagan Sharma, president and CEO at BSI Financial Services, questions whether servicers should be liable for advances and said that skin in the game can be achieved by other means other than having servicer advance payments.
"In our view, a servicer should not have to advance delinquent payments," he said. "It would be better to have the underlying investor take on the risk. I believe an alternative matrix can be created that ensures a servicer is working in the best interest of investors."
That might involve, he said, a trustee or another entity reviewing the servicer performance on an ongoing basis - similar to what they do in the whole loan space. Such a performance review might consist of not only reviewing payment activity but also adding criteria for effectiveness and appropriateness of loss mitigation techniques and different workout scenarios.
The servicer advance-based system has also led to consolidation in the market where, Sharma said, there are too few servicers that are typically part of depository institutions. He estimated that the top four servicers have 60% of the market. Changing the compensation scheme to a fee-based one would allow more servicers to compete for business.
Moreover, transitioning to a fee-based approach would not entail an overhaul of the current system. According to Sharma, BSI as a servicer of whole loans, for instance, already has a model in place that is similar to what is being proposed.
However, the biggest issue over fee changes will be finding a resolution over the skin in the game issue that regulators, servicers and investors agree upon.
"Different people are working on models and testing which will work out best," Sharma said. "At the moment, the market hasn't finalized a particular model because we really haven't seen too many [securitization] deals that have tested these new compensation models."
He believes that in the end it is likely that regulators will let the market workout which model works best and will opt to preserve some flexibility to whatever scheme is decided upon.
"The private market will need to have these questions addressed and done right, a good model will address the issue of delinquent loan servicing," he said. "Otherwise we could just end up with five to six big servicers with a somewhat similar special servicing scenarios."
Moving to the next model of servicing compensation
Current servicer compensation model based on fixed interest strip is not optimal
Hedging servicing asset is expensive and inefficient
* Little or no market for excess servicing
* Ultimately, higher hedging costs translate into higher mortgage rates
* High cost of capital under Basel 3 for capitalized servicing
* Current 'one size fits allâ€™ model pays too much for performing loans, too little for delinquent ones
* Consolidation has occurred in the industry
- Large servicers efficient with performing loans
- Inefficient at â€œhigh touchâ€ loans
* No mechanism to compensate servicers during periods of high defaults
- Necessary to be able to move servicing
One solution: move to a two-tier â€œfee for serviceâ€ model
* Fixed monthly fees for performing loans
* Higher fees for non-performing loans, along with incentive payments
* Servicing transferable if necessary
* No need to capitalize fee income; helps reduce capital cost and encourage new entrants
Less 'skin in the gameâ€™ in new world raises investor concern about 'churningâ€™ prepayments
Solution: prevent 'churningâ€™ through:
* Rule-based pooling
* Sliding g-fees based on historical prepayments / credit performance vs. overall cohort
Source: JPMorgan Securities