Servicers get slammed on regulatory risk
The federal government has taken numerous steps to reduce foreclosures. It started with loan modification programs. It’s also encouraging servicers to pursue other means of dealing with delinquent borrowers.
Loan servicers handle the day-to-day management of the loan pool for the ultimate investor. They’re responsible for collecting mortgage payments, forwarding the interest and principal to mortgage-backed securities holders, and handling delinquent borrowers.
Ever since various state regulators and the Consumer Financial Protection Bureau started leaning on Ocwen Financial (OCN), the servicing industry has been under tremendous regulatory pressure. Ocwen Financial stock has fallen by 94% over the past two years. Originator Nationstar Mortgage Holdings (NSM) has also been under intense pressure. It has fallen by ~42% over the past year. Walter Investment (WAC) is down 85% over the past year.
New capital requirements for MSRs (mortgage servicing rights) are also depressing valuations. Banks are reluctant to hold too much servicing. Many originators don’t hedge their MSRs against interest rate risk. Instead, they choose to treat the MSR portfolio as a hedge against the origination business. As rates fall, refinance activity picks up, but MSR valuations fall. The opposite phenomenon happens when interest rates rise. You can trade interest rate risk through the iShares 20 Year Treasury Bond ETF (TLT).
CoreLogic notes that the serious delinquency rate has been falling. In April, it was 3%—about 1.1 million homes. This was a fall of ~2.8% month-over-month. It was a fall of 22% year-over-year.
As you can see in the above graph, foreclosures as a percentage of all mortgages outstanding have been falling rapidly. In 1Q15, they fell to 1.7% of outstanding loans from 1.8% in 4Q15, according to the Mortgage Bankers Association.
Mortgage servicing rights are becoming a cheap asset
Mortgage servicing rights have always been a somewhat esoteric product in that very few investors are able to purchase them. Regulatory and licensing requirements will prevent most hedge funds and traditional asset managers from participating in the space. That said, MSRs generally have high cash flow yields, usually in the low teens. We’re seeing Annaly Capital (NLY) start to buy them. Other originators like Redwood Trust (RWT) and PennyMac (PMT) will have to watch servicing valuations compared to origination volumes.
Next, we’ll look at state foreclosure laws and how they impact home price appreciation.