The last two months have been a nightmare for mortgage originators and servicers.
The volatility in the bond market has made risk management difficult, while the decrease in interest rates has caused margin calls for investors and originators. Finally, the Coronavirus Aid, Relief, and Economic Security (CARES) Act pretty much mandated that mortgage servicers grant forbearance to anyone who can claim to have been affected by COVID-19. This can be a huge cash drain for servicers.
How have mortgage servicing assets been behaving as a result?
The number of mortgages in forbearance is falling
Mortgage servicing rights (MSRs) are a significant part of PennyMac Financial Services' (NYSE:PFSI) overall portfolio. Late last week, Black Knight announced that during the last week of May the number of mortgages in forbearance fell by 34,000 to 8.9% of all mortgages outstanding. This statistic, along with the recent Employment Situation report from the U.S. Bureau of Labor Statistics, indicates that the economy is on the mend as businesses reopen.
What are MSR assets?
MSRs are one of the stranger financial assets out there. Essentially, a mortgage servicer handles the administration of the home loan account, sending out the monthly statements, ensuring that the principal and interest payments go where they are supposed to, ensuring that taxes and insurance are paid, and handling delinquencies and foreclosures. The servicer is paid a fee for performing this service, usually about 0.25% per year of the mortgage balance outstanding.
So, if the borrower has a $400,000 mortgage, the servicer gets $1,000 a year to send out bills and collect money in the first year and a gradually reduced amount with each passing year till the mortgage is paid off. That servicing right is worth money, and the MSR on that $400,000 mortgage could be worth anything from $1,000 to $4,000, depending on assumptions about interest rates, expected delinquencies, the cost to service, etc.
Servicing advances can be fatal to undercapitalized servicers
Ordinarily, this is a pretty mundane business, but the last couple of months have been extraordinary. One of the negatives of being a servicer pops up when a borrower starts missing payments. First, it greatly increases the cost to service the loan, and when the borrower isn't paying the servicing fee, the servicer isn't getting paid. Second, depending on the mortgage, the servicer is responsible for making up for some (or all) of the borrower's missed payments. The servicer is generally always required to advance taxes and insurance, but it can also be required to advance principal and interest. The servicer will get this money back from the borrower; however, this can be a huge temporary cash drain. Mortgage servicers that are unable to come up with the cash for advances are in deep trouble, and they could find the asset basically taken away for no compensation. Due to fears about future liquidity, the market value of servicing mortgages has plummeted.
PennyMac has the liquidity to navigate this crisis
PennyMac's advance payment requirements are mainly taxes and insurance, not principal and interest, which gives the company much more breathing room than other servicers to manage the current downturn. In addition, the company announced on its earnings call that it has a $600 million facility to finance advances. So, these worst-case-scenario fears are not really applicable to PennyMac Financial Services.
In addition, the origination business should perform extremely well in the near future as record-low interest rates create an opportunity for borrowers to refinance their mortgages. Even though servicer advances aren't an issue for PennyMac, the market value for servicing can impact the financial statements. PennyMac wrote down the value of its servicing book during the first quarter, although it was able to recoup the losses with interest rate hedges.
Going forward, mortgage servicers should breathe a sigh of relief as it looks like the economy is turning around and we have seen the peak in requests for forbearance. This will support mortgage servicing valuations as the mortgage industry gets back to normal. The stock has recouped all of its coronavirus-related loss in the market and is now up for the year. The bright outlook for mortgage origination, plus a thawing in servicing values, should provide a bit of a tailwind for the stock, as well as for the entire real estate investment trust (REIT) sector.