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Refi’s Wreak Havoc on MSR Impairment

This has been a difficult year for servicers.  In addition to increasing costs and ever more regulatory burdens, we continue to see most of our new servicing coming from refinancings.  For the majority of servicers that do not utilize fair-value accounting, this can result in bloated temporary impairment reserves. This temporary impairment is really permanent, and should be written down as the loans pay-off.

From an economic perspective, refi’s are not beneficial to the servicing industry.  While the new loan added may be slightly more valuable than the pay-off due to higher balance, lower coupon and extended maturity, the increased value is oftentimes offset by the cost of paying off the old loan and setting up the new. 

Yet from an accounting perspective, many servicers add the value of the newly originated MSR to their capitalized servicing and continue to amortize the capitalized servicing on the old loan.  The theory behind this is that the amortization already reflects the expectation of premature pay-offs and thus, to write-off the loan, is redundant.  This, however, creates the opportunity for impairment when refi’s make up the preponderance of new originations.

To illustrate this, I took a hypothetical portfolio of 2,500 loans ($550MM) and valued it over six periods.  Each period has the identical prepay and other assumptions as the last.  Accordingly, the overall value hovered around 1.0% (5.5MM).  However, in each period I assumed that 100 loans refinanced.  The new loans have the identical characteristics as the old loan except for the origination and maturity dates.  Accordingly, the current principal balance of the servicing portfolio does not change over the time period reviewed.  The value remains relatively constant over time,  diminishing only slightly as the portfolio ages.  Basis equal to the fair market value of the new loans was added in every period, and amortization was calculated based on the portfolio’s decreasing economic life. 

The analysis was run twice: first with no write-off of the basis (“amortization only”) on the paid-in-fulls.  Amortization is thus relied on to keep the basis in line with market value; and second, with a “write-off” of the paid-in-fulls’ bases as the loans are refinanced.  The differing results are dramatic.

Amortization Only – The red line on the graph below shows the rapid escalation of basis as new loans, and their respective bases, are added.  This is, admittedly, an extreme scenario.  I have assumed a high volume of pay-offs, all of them are refinances, and 100% of the refis are recaptured by our hypothetical mortgage servicer.   It is clear why the impairment is growing so rapidly in this scenario.  The growth in basis is substantial and, while amortization is growing as well, the net of the two fails to adequately reflect the fact that the market value of the portfolio is essentially unchanged over this time period.  Since market value of the overall portfolio is essentially static, impairment grows exponentially. 

Write-off – Comparing that however, to a Write-off scenario, where the basis on paid-in-fulls are written down, the dynamics change dramatically.  The green line in the same graph shows the basis as adjusted for the write-off of the old refi’d loan.  As is evident, there is no impairment under this scenario.  The “write-offs” are simply recognizing as a permanent impairment that which would be considered temporary under the Amortization Only method.  Since the resultant basis is lower, this approach has the additional benefit of reducing amortization going forward.  Over time, there is no difference in the two methodologies.  100% of the basis will be written off eventually, it is just a matter of when and how. 

Writing-off the basis on loans that have refinanced may not be popular with the folks in originations.  After a particularly good month of originations, no one wants to hear that the net effect on the bottom line approaches zero.  However, we are deluding ourselves, in a high refinance environment, in thinking we are making progress.  The refinance business, from a servicer’s perspective is at best a zero sum game.

The mortgage industry’s growth has historically been driven by population growth and real estate appreciation.  In this growth scenario it may be defensible to add the basis on the purchase money loans added and rely on amortization to reflect pay-offs.  Neither is the case today.  Absent immigration, our population is expected to be stagnant through 2050, and real estate values continue their inexorable decline towards more sustainable levels.  Our total industry servicing rights accordingly, are not growing.  We are simply moving them around from one company to another.  In this environment, it is prudent to write-off loans that that have refi’d.

 As published in Mortgage Banking Magazine, May, 2012

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