Mortgage servicing rights and interest rates
Mortgage servicing rights (MSRs) trade similarly to interest-only (IO) strips. When a treasury bond is broken into its basic components, it creates treasury strips. A bank may issue one bond with only the principal payment (effectively turning the bond into a zero-coupon bond) while at the same time issuing another bond that’s simply the stream of coupon payments. The bank can even issue a stream of zero-coupon bonds based on the coupon payments.
In a mortgage, the number of interest payments is uncertain. Due to prepayments, the number could be anywhere from a few mortgage payments to a 30-year stream of payments. To calculate the value of an MSR, you need to estimate the life of the mortgage servicing right and discount the cash flows at the proper rate.
When interest rates go up, the risk of prepayment falls. For example, a servicer like Ocwen (OCN) may have a baseline prepayment assumption for their portfolio of MSRs. The life of the MSR will be a function of the average note rates on the underlying mortgage and how they compare to existing mortgage rates. If rates rise above the note rates underlying the MSRs, then prepayments will be more or less limited to people who move, and the cash flow stream may end up lasting ten years.
Although this information is less relevant at the moment, when short-term rates increase, holders of MSRs get an additional benefit—float on the various accounts. For example, your mortgage payment date may be on the 1st of the month, but the servicer may not have to remit payment to the MBS (mortgage-backed security) holder until the 20th. Between the 1st and the 20th, that money sits in an account, earning interest. The servicer is entitled to that interest. Property tax payments are usually due twice a year, and the prepaid taxes earn interest as well. So once interest rates start rising again, mortgage servicing rights should increase due to float earnings.