At the start of 2020, the commercial banks were expanding into
The decline in the bank share of mortgage servicing comes as nonbank lenders are taking the lion's share of the expansion of volumes. Large nonbank lenders such as Rocket Mortgage, PennyMac, Freedom Financial and Mr. Cooper are taking the biggest share of refinance volumes across retail, direct and correspondent channels as the commercial banks withdraw.
Michael Fratantoni, chief economist of the Mortgage Bankers Association, recently wrote about the retreat of banks from residential lending and servicing:
"It is important to note that a growing share of mortgage originations can lead to an increase in the servicing share, as originators often have the option to retain or sell the servicing on a loan," he wrote in a column for International Banker. "Many nonbank originators (independent mortgage bankers, or IMBs) tend to be opportunistic, for example, retaining mortgage servicing assets when market values are low, selling when they are high."
All areas of loan sales by banks are shrinking as depositories withdraw from third-party acquisition of assets. Bank sales of auto loans and C&I credits have essentially gone to zero in 2020 while sales of one-to-four family mortgages have likewise fallen — this even as mortgage industry production volumes have generally risen by 30-40% for the industry in 2020.
Of note, the brief increase in bank one-to-four-family assets serviced for others above $6 trillion at the end of 2019 has been reversed in the past two quarters. Meanwhile, nonbank servicing will exceed $4 trillion by the end of this year as the industry heads for $12 trillion in total loans.
At the end of the second quarter of 2020, assets serviced for others by all U.S. banks fell to $5.7 trillion, compared with $6 trillion at the end of 2019. More important and to Fratantoni's point above, bank sales of one-to-fours have fallen precipitously since 2016, from $680 billion sold in 2Q 2016 to just $448 billion in 2Q 2020. And as the servicing balances and loan purchases by banks have fallen, so too has the value of bank-owned mortgage servicing rights, as shown in the table below.
Of course, a big part of the decline in bank MSR valuations is a result of falling interest rates and related assumptions for elevated prepayments. When a consumer exercises their right to prepay a mortgage, the owner of the MSR sees their asset evaporate — unless the servicer is able to recapture the asset via a refinance transaction. That ability to identify and close a refinance opportunity is the key skill set for mortgage lenders today.
For the top lenders noted above, the percentage of recapture rates on government loans are well into the 70s and 80s. But for smaller issuers and end-investors such as REITs and funds, prepayments are a serious threat to their continued existence.
The Federal Open Market Committee can accelerate lending with low rates, but it cannot ameliorate either the negative impact on credit years from now or the torrent of loan prepayments today. Many REITs and funds are currently attempting to raise cash by levering-up MSRs that likely won't exist a year from now. This is one reason that the book-value multiples for publicly traded hybrid REITs have collapsed.
Owners of legacy mortgage servicing also face the prospect of reduced or even negative returns due to the cost of remediating defaults and forbearance loans due to COVID. And by no coincidence, valuation multiples for MSRs have fallen by two-thirds since 2018. Meanwhile, residential mortgage lending markets face an extended boom and the public equity market valuations for nonbank lenders are soaring.
In this Fed-driven market, if you are not among the handful of hyperefficient lenders able to actually grow your servicing book net of loan prepayments, then you're probably a victim. Without a strong partner in terms of both servicing and recapture, one operator tells NMN, most end investors in MSRs such as hybrid REITs could be well advised to consider selling their remaining assets while the opportunity remains.
Since Federal Reserve Board Chairman Jerome Powell has made clear that short-term rates in the U.S. are unlikely to move higher in our lifetime, the only rational strategy for holding MSRs is to be very aggressive on protecting the servicing assets via loan recapture. This is one of the chief reasons that banks have been willing to give up share in lending and servicing of one-to-fours as they collapse back to retail-only lending strategies.
Simply stated, banks and REITs buy loans, IMBs make loans. Holding MSRs when you cannot defend the asset by recapturing the refinance event is a losing trade. This is why, for example, that early buyouts of government loans is such a popular strategy with large banks. Buy the delinquent asset, modify or refinance the loan, and sell it into a new MBS pool or just hold the loan in portfolio.
Until such time as the FOMC decides to allow short-term interest rates to rise, the nonbank share of mortgage servicing assets is likely to grow, but the composition of that nonbank constituency is going to change. Look for fewer, bigger nonbank issuers that are creating and retaining newly minted MSRs in portfolio at rock bottom valuations. And look for many fewer REITs and funds in the residential sector because of the huge premium today on the ability to efficiently create new loan assets.
