As servicing gets more complex, it often takes two to tango

Subservicing is increasingly becoming a tempting strategy for mortgage companies looking to rein in rising compliance and operational costs. And with an influx of capital markets investors buying up mortgage-servicing rights portfolios but lacking the infrastructure to actual manage the loans, demand for subservicing is on the rise.

"We're seeing smaller servicers that are going to service the transaction but we're also seeing subservicing," said Bill Fricke, a vice president and senior credit officer at Moody's Investors Service. "I wouldn't say one's more prevalent than the other. We're seeing both, but I think there has been more subservicing than in the past."

Subservicing is a mixed blessing for nonbanks that tend to offer it when they want to augment their businesses. Ocwen, for example, put more focus on subservicing after it faced regulatory constraints on its MSR acquisitions.

"Subservicers have to do the same things they would have to do as a primary servicer," said Fricke. "The service fee could be different, but from a pure operational servicing standpoint, for a company like Ocwen to service or subservice, essentially they're doing the same thing."

Nimble nonbanks with strong capital resources tend to be the best equipped to contend with the temporary nature of subservicing contracts. But the run-up in post-crisis regulation has increased the costs associated with both origination and servicing, eating through companies' capital reserves more quickly than in the past.

For a long time, low rates have helped boost origination volumes to help offset that erosion. But since rates rose last fall, lenders' volume-driven profits have declined.

The silver lining in this could be that if rates keep rising, lenders might get more for their MSRs if they sell their loans servicing-released. This allows them to get the value from their MSRs upfront instead of over time.

Small- and medium-sized lenders have found selling servicing-released more attractive recently, said Danny Jasper, senior vice president in capital markets for Castle & Cooke Mortgage in Draper, Utah.

"There's a higher value in monetizing servicing. There has been more of a competitive environment as it relates to more individuals getting into the servicing buying game. People are interested in the potential growth," he said. "We've been able to secure more liquidity and secure better spreads if we choose to release that servicing. We've got better pricing options and we can push that out to our originators."

The percentage of first mortgages sold servicing-released by independent mortgage bankers rose slightly to 71.77% from 69.7% between the third and fourth quarters of last year, according to a Mortgage Bankers Association survey.

Another opportunity that has arisen for moderate-sized players lies in the servicing of the private-label residential mortgage-backed securities.

The number of new and legacy private-label RMBS loans serviced by top-four servicers declined over the past three years, while share among smaller institutions grew, according to Moody's.

"Ocwen, Nationstar and Walter are still the big three, but we're seeing more diversity from small-to-midsized players gaining in market share; and we think that's good from a concentration risk standpoint," said Fricke. "What's driven that is some of the financial/regulatory issues that the bigger servicers have had. It's opened up some opportunities. While there may be deconsolidation among servicers in the private-label RMBS market, concentration risk is a concern in the Ginnie Mae subservicing market.

A big chunk of that market "is concentrated in a handful of large subservicers," said John Newlin, an executive with Accenture's credit consulting practice.

MSR holders that outsource to subservicers are closely watching this counterparty risk because it's the named servicer that is ultimately liable for the risk.

"Obviously, if you have the operations you also have compliance concerns. Instead of taking all that on, it's easier at times just to subservice it out. The key to remember here is that even if you utilize subservicing, you're still ultimately responsible for the servicing and performance," said Fricke. "For subservicing, oversight is the key. You have to make sure you have good oversight because you're still on the hook, technically, for all the regulatory issues."

There is also ongoing concern about the extent of risks concentrated with nonbank issuers in the Ginnie Mae market. Ginnie Mae nonbank issuers have constituted roughly half the market in recent years as opposed to a minority of the market in the past, and Ginnie has been concerned about whether they have sufficient liquidity.

Will banks continue ceding share to nonbanks? Or will the market reach a point where servicing becomes more attractive and banks jump back in?

Banks still see some opportunity in servicing, particularly with agency loans that have high credit quality and more standard guidelines.

"Banks have a cheaper cost of funds. They create the asset themselves and a lot of the growth in the nonbank sector has been Dodd-Frank related," said Dio Mejia, an associate at Standard & Poor's Global Financial Institutions Ratings.

Banks could return to the market if changes in the regulatory environment reduced the costs and liabilities associated with servicing. Also, if rates rise, servicing portfolios take on a greater importance as a base from which to sell other products to consumers.

"A great opportunity that people have is that they've aggregated a number of customers over the last several years at historically low interest rates," said Kevin Brungardt, CEO of RoundPoint Mortgage Servicing Corp. "For people that own mass positions of customers with this type of duration, you're going to see people really focus on what are the other revenue opportunities for these customers?"

Cross-selling opportunities could make servicing more attractive to banks, as well as nonbanks that sell other financial services products.

But unless regulatory responsibilities and complexities are scaled back, banks are likely to remain wary of the servicing business.

"It's not like servicing has crazy profit margins," said Mejia. "Other than the in-house client relationship, servicing is not something banks are dying to get back into. There's just so much regulatory scrutiny."