_Ellen R. Marshall is a partner and co-leader of the Banking and Financial Services Practice at Manatt, Phelps & Phillips, LLP._
The value of mortgage servicing rights (MSRs) may be changing and the market for acquiring MSRs may be heating up. This market phenomenon is the result of the proposed Basel III capital rules applicable to banks.
[IMAGE]For non-banks, the Basel III rules may seem irrelevant, but that could be a mistake. The Basel III rules could change how MSRs are priced, who owns the MSRs, and ultimately which servicers handle servicing for the loans that relate to the MSRs. More importantly, for non-banks, these MSRs may present interesting investment opportunities.
First some background. MSRs represent the right to receive an interest-only (IO) strip from a pool of mortgage loans. Ownership of the MSR entitles the owner to receive this IO strip in exchange for providing the servicing function.
The owner can service the loans itself, if it has the infrastructure to do so, or the owner can engage a subservicer to do the servicing function.
Banks are required to hold capital in proportion to their assets, including MSRs they hold. Under the risk-based capital system that has been in place since 1992, asset-types have been risk-weighted for purposes of calculating capital requirements, and MSRs have carried a 100% risk weighting.
This means that the amount of capital that banks must hold with respect to the MSR assets is the same as much as would be required for an equivalent amount of most other assets, such as commercial loans or corporate bonds.
Under the proposed new Basel III capital rules, the risk weighting for MSRs would dramatically increase to 250 percent. For any portion of the booked value of MSRs that exceeds the after-tax gain on sale, the risk weighting increases to a sky-high 1,250 percent, heavily penalizing the holding of these MSRs assets.
[COLUMN_BREAK]In addition, there would be a 10 percent limit on the share of a bank's capital that can be furnished by MSRs.
Why do the Basel III proposals impose so dramatic a change in the carrying costs for MSRs? It is interesting to speculate that the international bankers who formulated the international accord that formed the basis for Basel III blamed the U.S. mortgage market for the financial crisis of the last four years.
Banks in the U.S. have far more MSRs on their books than do the banks in other countries. On the other hand, perhaps the higher risk weighting reflects a perceived level of risk that was exposed during the financial crisis and is inconsistent with safe and sound banking principles.
In any event, it is ironic that MSRs are proposed to be treated as more risky now than they were in the past. The return on MSRs is strongly and inversely correlated with the prepayment speeds of the underlying loans.
Prepayment speeds turn on the extent to which loans are terminated due to refinancing, home sales and foreclosure. With interest rates at all-time lows, home sales still relatively slow, and foreclosures declining, we stand to see prepayment speeds slow dramatically in the coming months or years.
As a result, MSRs may be a less risky investments than at any time since the risk-based capital regime began. Nevertheless, if the U.S. regulators' rules are adopted as proposed, the risk weighting of MSRs on banks' books will rise dramatically as will the cost of capital required to retain these assets.
Therefore, banks will be motivated to sell their positions in MSRs. For non-banks, this could create a buyer's market for these rights. Importantly, when a portfolio of MSRs changes hands, in most cases the buyer will have the right to change the subservicer. If the buyer is itself in the servicing business, it could assume the servicing role. If the buyer is not in the servicing business, it can direct the servicing to its preferred servicing provider.
Either way, there is a developing investment opportunity for servicers to joint venture with non-bank investors (such as hedge funds) to purchase MSRs at depressed prices, and to move the servicing, for the benefit of both venture partners.
Since the final form of the Basel III capital rules has not yet been adopted it may be a bit early to launch such an investment, but it is not too early to think about how such transactions would be structured if the final rules follow the proposal. At the moment, many industry participants are lobbying the regulators to adopt a less burdensome rule, and the final version could differ substantially from the current proposal.