The MSR Market Is Soaring, But Challenges Await

This piece originally appeared in the August 2022 edition of DS News magazine, online now.

One day, we may all look back at the 2020-2021 housing market and marvel at the confluence of factors that sparked the longest and most active refinance market we may ever see. But like all good things, that party has come to an end—and an abrupt one at that.

With rising rates, the spotlight has now shifted to other opportunities, and one of the brightest may be the market for mortgage servicing rights (MSR). It may not grab the headlines like the origination market did, but the increase in MSR values is something for servicers to feel good about. However, in the not-too-distant future, this party may also end abruptly—unless organizations start thinking strategically about how to best manage these assets in an increasingly complex and challenging environment.

How Quickly Things Changed
Many of us look at the housing market fundamentals and create a crystal ball in our minds about where we think the market will go and the reasons why. Yet there was a great deal of surprise in how quickly the current market shift occurred and how different everything looks from just six months ago. In fact, over the past five months, interest rates rose faster than any period in the past four decades.

Surprising or not, for the most part, companies in the MSR space reacted to the new market dynamics rather quickly, and a buying spree for MSRs that began last year continues today. We’ve been witnessing eight and nine companies at a time bidding on packages, even for low coupon products. We’ve already seen plenty of disconnected pricing, with some paying outrageously high multiples for MSR assets.

It’s obviously a great time for MSR sellers. In fact, it’s a lot like the current real estate market—it’s a great time to sell because there’s not a lot of inventory, and prices are soaring. But it’s not a bad time to buy MSRs, either, given the profits that can be made in today’s higher interest rate environment.

I believe most buyers are overpaying for these assets. There are a lot of companies out there with capital and a mandate to deploy that capital at all costs. However, there is a risk that many are paying too high a price. If the assumptions in their business models prove to be wrong and they don’t see the returns they thought they were going to get, it may cause problems down the road. For some MSR buyers, there will be a time of reckoning when the chickens come home to roost.

Challenges That Lie Ahead
My company too has been a very active buyer of MSRs both on a bulk and flow basis. However, we are bidding prudently. Frankly, the prices some others are offering for packages are silly based on what we think is going to happen in the economy in the next 12 to 18 months.

In fact, while MSRs are a profitable business right now, the magnitude of that profitability will likely change and narrow, because servicing challenges and costs are both heading higher.

While it’s impossible to predict what’s going to happen beyond a single day with any accuracy, the entire housing market is probably going to be less favorable in the coming year.

The way we think about the markets is very big picture. Employment, rates, housing affordability, and what’s happening from a geopolitical perspective—including Ukraine and the cost of oil—are all going to put downward pressure on the economy, which is going to be problematic in our space.

The reality is that many MSR buyers that have been in the market for some time do a great job at understanding cost of servicing.

But others don’t. Inevitably, some MSR buyers will bite off more than they can chew—or already have. Too often, a servicer that tries to be everything to everybody will find themselves looking for ways to cut costs and cut corners, which often results in internal control issues. It can also lead to a worse customer experience, which can put them in the crosshairs of the Consumer Financial Protection Bureau (CFPB) and other federal and state regulatory agencies. It can create institutional risks with their selling partners, too.

And while mortgage defaults remain low, the prospect of a recession in the next year could change that scenario. If defaults do happen to rise, servicers and asset owners will have to spend a lot more time managing those assets, which is a much more high-touch process. Subservicers can simply charge more fees. But if you’re servicing these assets in house, your expenses are going to rise exponentially because you’re going to be spending more time on them. And if you struggle to have the infrastructure in place to begin with, you’ll have to build it.

Ultimately, we believe there’s going to be some normalization, contraction, and compression around MSR margins, which will result in these assets being less profitable than they are today. We expect to see a lot less MSR flow in the marketplace and more portfolio retention. But whether they plan to buy, sell, or retain assets, servicers have plenty of options.

Relationships Are Key
For servicers that do want to sell MSRs, it helps to have a subservicing partner that is able to take those MSRs off their hands directly. Selling them somewhere else requires paying boarding fees to the new buyer, and if those assets are already being subserviced, there’s a deboarding fee involved as well. Depending on the type of assets, there may be other expenses included, such as recertifying pools. Having a subservicer that can service the assets you want to keep, and buy the ones you don’t makes everything so much easier.

For companies that are originating and selling MSRs on a flow basis or originating and retaining MSRs to sell later, having a strategic partner in place that supports the servicer’s business model is key. Many companies choose to retain MSRs, but don’t want to manage the servicing risks, and there are subservicers available that can offer them great execution.

For those that want to sell MSRs down the road, there are also subservicers available—though fewer of them—that have strong capital partners and will be able to take MSRs off their hands without paying extra onboarding or offboarding fees. For most firms, forming a strategic partnership with such a subservicer is the conservative and sensible approach.

This is also a good time to be flexible and nimble, especially if you have more assets and different types of assets than you can reasonably handle. If you need to offload MSRs, your partner should be flexible and nimble as well.

Some buyers in this space—especially very large ones—have arduous processes that sellers must go through in order to sell MSRs. The ideal partner is typically one that is not so big yet still has good capital partners in place.

If you’re selling MSRs, however, you want to work with buyers who understand the fundamentals of the market you operate in. Rather than finding the company that offers the best price, the goal should be finding a company with which you can have a mutually beneficial partnership. Holdbacks and other issues can typically derail transactions after they are executed, but with the right partner, this can easily be avoided.

Sellers will also want to make sure the buyer has a good market reputation. Borrowers will complain about servicers that treat them badly, and if a lender is fortunate, the borrower won’t see the connection between lender and servicer. In some cases, however, they will make the connection and will not think highly of the lender that chose to sell their loan to the servicer that treated them poorly. Is losing a repeat borrower or a cross-selling customer worth the risk?

If you’re retaining and considering hiring a subservicer, that subservicer’s reputation is important, too. Companies need to make sure their subservicing partner has serviced similar sized portfolios and assets. If you have a $35 billion portfolio, and the subservicer you’re thinking of partnering with only manages $10 billion in assets, they’re probably not going to be a good partner. The same applies if you have a portfolio of Fannie loans and the subservicer specializes in fix-and-flip properties.

Lastly, servicers should look closely at the management team and their backgrounds. Are they steeped in the servicing business and understand it front to back? Or is the leadership team comprised of former investment bankers, who typically do not make the best servicing experts. At the end of the day, you want to have confidence in the management team so that when trouble arises—and it always does—you know they will handle it. It’s the management team that sets the tone for the entire operation, which trickles down to the boots on the ground.

No doubt about it, the MSR market is hot right now, and with all the struggles happening on the origination side of the business, there’s no harm in enjoying the ride. But servicing comes with its own set of challenges that will only grow in the months ahead. Regardless of their strategy and business goals—whether it’s selling or buying, now or down the road—having the right relationships in place will make future market shifts much easier.