Navigating the MSR Opportunity Part II in a Two-Part Series from Steadfast Capital, LLC

by Ballard Spahr LLP

In Part I of this series, we reviewed some of the fundamental considerations inherent to retaining mortgage servicing rights (MSR), including updating capital plans with sophisticated pro forma analysis, "retain versus release" considerations, and determining the appropriate amount to be capitalized. A number of other decisions must be made.

Will the company hire a subservicer, or handle this function internally? In most cases, outsourcing to a subservicer makes sense, but there are some pitfalls to avoid. First, know that subservicing is not high-touch, and in any case the agencies will hold the owner of the MSR responsible for all aspects of proper loan administration and customer service. In fact, Fannie Mae requires that at least one employee possess meaningful servicing credentials. In our opinion, carefully monitoring the subservicer and augmenting its services with employees of the MSR owner is critically important. Second, recognize that the current subservicing demand is very high, and some of these shops are likely already operating beyond maximum effective capacity. Third, outsourcing regulatory risk sounds great, but only if a creditworthy counterparty can stand behind the services being provided. The implications of these potential pitfalls are obvious, so select carefully!

There are other considerations to keep in mind about accumulating a servicing portfolio as the MSR becomes more material to the balance sheet. For example, what financial covenants are being imposed by the company's warehouse lenders? Some banks are playing catch-up on this issue and may have unreasonable/arbitrary caps on MSR as a percentage of net worth. Don't be reluctant to challenge them on this or find another funding source! Also, should companies consider hedging to protect run-off risk? This is worthy of careful consideration, but adds to working capital demands and curtails upside in return for downside protection.

Should companies not affiliated with depository institutions consider raising capital or seeking structured term financing, permitting them to retain a greater amount of MSR? While it is accurate to say that there has been a funding gap in terms of availability of such capital/financing, we believe this is rapidly evolving. Adding new capital does not necessarily mean selling a piece of the company, and we believe the required yields inherent to certain types of term debt or preferred stock can result in effective leverage of the MSR investment and can be highly accretive. The cost of this new capital will be commensurate with the strength of the mortgage bank's balance sheet, earnings history, quality of management team, and duration of the instrument. Although such capital is harder to obtain and certainly more expensive, we believe in most instances companies will be better served by adding capital with duration closer to that of the MSR being accumulated.

Once upon a time in the mortgage industry, virtually all mortgage companies retained the MSR on the loans they originated. Attention to loan quality and subsequent performance was paramount, and investor relationships were cherished and carefully nurtured. A strong argument can be made that it is time to go "back to the future." Opportunities are tremendous, but the industry is rapidly evolving, and the regulatory environment requires serious attention, not just on the origination side, but on the servicing side as well. Successful companies will hire good counsel to ensure regulatory risk is properly assessed, and bring in outside experts to assist with MSR analytics, refining capital plans, and potentially raising new capital.  

- David Fleig

About the author: David Fleig is President and CEO of Steadfast Capital, LLC, a boutique investment firm primarily focused on providing capital and strategic solutions to the mortgage banking industry. Steadfast's analytics division provides independent MSR valuations and related analytics to its bank and mortgage company clients.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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