With the passage of the CARES Act, homeowners with federally backed mortgages who are experiencing financial troubles due to the novel coronavirus crisis are can request a forbearance on their loans. That will allow those borrowers to pause their mortgage payments for up to 180 days.

This has caused the market value of mortgage servicing rights (MSRs) to collapse, as the government has decided to not provide a credit line to servicers, which will still face huge cash commitments. What does that mean for large non-bank mortgage servicers?

PennyMac Financial Services (NYSE:PFSI) is one of the top non-bank mortgage originators in the U.S. It originates loans and sells a large share of them to its sister REIT, PennyMac Mortgage Investment Trust. PennyMac Financial Services retains the mortgage servicing rights. Its mortgage servicing portfolio is valued at $2.9 billion, and amounts to about 29% of its assets.

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What is a mortgage servicing right?

A mortgage servicer is the entity that collects your monthly payments, makes sure those funds go to the end investor, maintains the escrow accounts, and handles the foreclosure if you default on your loan. In return, the servicer is generally paid a fee depending on what type of loan it is. Since the costs involved in servicing a loan are generally much lower than the servicing fee, the right to perform this service is an asset valued typically using a complicated model. The value of servicing is sensitive to assumptions about defaults, and the CARES Act ensures that expected defaults will be materially higher than they were at the end of 2019.

Where is PennyMac facing some pain?

One of the biggest negatives for a loan servicer happens when a loan goes into default. Depending on the type of loan, the servicer may have to cover the missed payments and reach into its own pocket to make sure the investor is made whole. In other words, if the borrower doesn't pay, the servicer pays. The servicer will get paid back these advances once the matter is settled, but that could be months or years down the road. This timing issue will create a cash drain on many non-bank servicers. Mark Calabria, the head of the Federal Housing Finance Agency (FHFA), has declined to make a facility available for servicers to borrow the funds needed.

Fortunately for PennyMac Financial, the advance payments are largely for tax and insurance escrows, not principal and interest, which means the cash requirements will be lower than many other non-banks. PennyMac also has lines of credit available to draw upon.

Unfortunately for PennyMac Financial, not all servicers have borrowing facilities in place, which has meant the market valuation for servicing has taken a dive. Fannie Mae servicing is currently trading in the market at 0.25% to 0.5% of the unpaid principal balance. Ginnie Mae servicing is 0.25% to negative. PennyMac is valuing its servicing asset at $2.9 billion, which is 1.3% of the $226 billion unpaid principal balance. In other words, if PennyMac wanted to sell that portfolio in the market, it could be looking at something materially lower than its current valuation on the balance sheet. Luckily, mortgage servicing rights are considered Level 3 assets, which means there is no active market for the asset to determine its value. This is because mortgage servicing rights are not homogeneous. Each loan has different characteristics, so the value of PennyMac's servicing book can differ from, say Wells Fargo's servicing book. This means the company has to use a model to value its book.

What's ahead?

Regardless of market pricing, the value of the MSR asset will be negatively affected by increased defaults and prepayment speed assumptions. Estimates vary regarding how many borrowers will take advantage of the forbearance opportunity, but they are anywhere from 2% to 25%.

PennyMac mentions in its 10-K that the primary inputs to a servicing model are the discount rate, the prepayment rate, and the cost of servicing. Most servicing models include an input for delinquency assumptions, so it is possible PennyMac's model takes those into account but doesn't consider them to be the major drivers. In normal circumstances, that is probably correct. Regardless, we know both prepayment speeds and delinquencies are going up, and that means the value of the MSR portfolio is going to go down.

It may turn out that Washington comes up with a facility to help the servicers, either through legislation or via a line of credit from the Federal Reserve. Calabria was simply saying that Fannie Mae and Freddie Mac cannot provide that line of credit. That said, the non-bank servicers will face additional cash demands going forward, and the drop in the market value of servicing tells you that the portfolio is going to take a hit. At 29% of assets, it could have a material impact on PennyMac's balance sheet and dividend