We have had an inverted yield curve for quite some time now.  Over the last quarter, however, it has reverted to the more normal positively sloped yield curve.  This is a double-edged sword for owners of mortgage servicing rights.

Negatively sloped yield curves imply, to most economists, economic weakness and a heightened probability of the economy going into recession.  This is obviously not good for anyone.

However, now that we have a slope that is positive, owners of mortgage servicing rights are faced with decreasing servicing values.  This is due to three factors:

1. Discount rates used to net-present-value future cash flows have risen significantly over the last quarter. Due to the fairly long duration of the servicing asset, discount rates are based off of the long end of the curve.  As these rise, net present value declines. Discount rates are the second most important assumption (just behind prepay speeds) when valuing mortgage servicing rights.
2. Ordinarily, a rise in rates would also add additional revenue from float on escrows, mitigating #1. This has not happened this quarter, as rates on these shorter duration funds have, in fact, dropped. Accordingly, earnings on the float generated from principal, interest, taxes & insurance have declined significantly as well.
3. The decline in probability of a recession helps mortgage servicers, but not much. Most default costs are absorbed by the holder of the mortgage assets themselves, not the servicers. The un-reimbursed projected cost of defaults that are incurred by servicers is dwarfed by the impact of #1 and #2 above.

Accordingly, servicers this quarter are enduring a double-hit: (1) increased discount rate, and (2) lower earnings on escrows. Servicing values need to be stress tested, not only for parallel increases/decreases in rates, but also for “twisting” of the yield curve.

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