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MSA Limits in Basel III

The proposed capital rules under Basel III would limit capitalized mortgage servicing assets (MSAs) to essentially 10% of Tier 1 capital.  This could adversely impact servicing market values.  Accordingly, I took a quick look at whether or not there may be a problem.  My conclusion is that there may be some dislocations at the bank level, but there is not a substantial systemic risk to servicing values.

There were 7,941 banks and thrifts in the United States as of 3/31/2010.  Of these, 1,137 had capitalized servicing (MSAs) on their books.  67 of these institutions had MSAs that exceeded 10% of Tier 1 capital, the remaining 1,070 were under 10%.  The bad news is that in order to reduce their MSAs to 10%, the 67 institutions would need to reduce their holdings by $24.8B.  This equates to approximately $2.8T of mortgage servicing principal balance at an assumed value of 90 basis points.  The good news is that the remaining 1,137 institutions, that are under 10% concentration, have adequate capital to absorb essentially all of this $2.8T ($2.6T anyway) if so desired.  This assumes that the banks that currently have no servicing wish to remain that way (a good bet for the most part).  It also assumes that non-bank mortgage servicers will not absorb some of this product.  This is probably not the case.

There are several ways an institution can address their overage:

  • Sell part of the portfolio – Only 28 of the 67 “over limit” banks are over by greater than 10% of Tier One capital and may need to sell. Their overage aggregates only $350B of servicing principal balance. 
  • Accelerate amortization and sell more loans servicing-released – It is conceivable that the other 39 institutions will manage their concentrations down through a more accelerated amortization combined with more servicing-released sales.  Additionally, normal prepayments and curtailments will also reduce their exposure materially before the proposed regulations take effect in 2012.  

Implementation of these capital limits, while non-sensical, should not create a large supply/demand imbalance and, therefore, should have little impact on servicing value. 

NB … please let me know if you would like to see the bank level data that went into this analysis.  Also, I would appreciate your thoughts on this subject.

2 Responses to “MSA Limits in Basel III”

  1. Desi Erasmus

    “Implementation of these capital limits, while non-sensical, should not create a large supply/demand imbalance and, therefore, should have little impact on servicing value.”

    It’s not obvious to me why the limits are nonsensical. A look at the past volatility of servicing rights valuations might make the statement more understandable. Are there any good refences for this? One that I found makes the following statement:

    “Since the introduction of FASB Statement 122 in 1995, mortgage bankers have been required to capitalize originated mortgage servicing rights (MSRs). MSR values are extremely sensitive to changes in forecasted prepayment driven by interest rate movements and are reported at fair value or the lower of their fair or carrying values with losses flowing through earnings Most mortgage banks both originate and service mortgages and the origination franchise serves as a “natural hedge” for servicing rights risk. However, the accounting treatment of MSRs creates a serious earnings timing difference between the recognition of servicing rights losses and the income from mortgage origination that exposes even an economically (cash flow) hedged mortgage bank to serious earnings volatility. In this paper we develop a simple mortgage banking model and simulate earnings paths under a stochastic model of interest rates. Our preliminary results suggest that short-term earnings volatility induced by the asymmetric accounting treatment of the servicing and origination franchises is marked and persistent. As a result, many economically hedge mortgage banks will have incentives to take uneconomic hedge positions against their servicing rights portfolios.”

    To the extent that statement is on target, it certainly makes sense to me why regulators concerned with bank safety and soundness would have some difficulty in allowing much capital credit for MSR assets, and limiting the participation in such assets.

    Reply
  2. tomhealy

    Thanks so much for your comment, you raise a good point. I certainly would agree that any asset concentration has its risks and, thus, is fair game for the regulators. I would argue, however, that the reason for the 10% seems to be more for international consistency than prudence. I have not been able to find any empirically supportable reason for this number. It seems to be arbitrary and, in my mind, restrictive.

    I think that the imposition of this limit simply mitigates the volatility introduced by LOCOM (lower of cost or market), as well as the assymetry of accounting treatments you mentioned (i.e. the “economic hedge”). Absent those two accounting distortions, MSR volatility would be much less.

    Reply

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