During the early 90s, I managed a wholesale mortgage bank that retained around $1.5 billion of the $5 billion of loans we originated.  Up until the mid-90s, servicing was considered an off balance sheet asset and income was derived from servicing the loan.  When our portfolio reached $1 billion, we generated around $3 million in annual income from our servicing portfolio.

When the Financial Accounting Standards Board (FASB) – through pressure from public mortgage banks – approved purchase servicing rights (PSR) to be capitalized and taken into current income, the world change forever for  small to mid size mortgage bankers.  The large public mortgage banks with the ability to raise capital and borrower money to finance the acquisition of servicing rights began a strategy of using part of the value of the servicing rights to subsidize pricing.  Small mortgage banks could not compete and many were forced to sell loans with servicing rights in order to maintain a competitive price with larger well capitalize companies.  Only a few independent companies like Provident Funding retain servicing as business strategy today.

During our visits to mortgage companies, we often get asked: Does it make sense to retain servicing?  And, if it does, when should be it considered.  We contacted Doug Mayers of Mortgage Industry Advisory Corporation (MIAC).  MIAC provides mortgage participants with industry standard software solutions for the valuation and risk management of the mortgage pipeline, mortgage servicing rights (MSRs), whole loans, mortgage residual interests, and interest rate and mortgage derivative instruments.  

First, Doug stated that scale is a primary consideration.  Without a minimum amount of servicing assets, it will be difficult to establish and manage the valuation of a servicing portfolio.  Prepayments are one of the assumptions used in establishing the value and a small portfolio could have large swings in prepayments from period to period.   These large swings would create volatility in ongoing valuation calculations.

After one commits to building a servicing portfolio, an analysis should performed on each loan considered for loan servicing to determine whether it makes financial sense.  In other words, is the economic value of retained servicing higher than the value received from selling it as part of a secondary market loan sale?  

In order to establish the economic value, a mortgage banker will use several assumptions:  Prepayment speed forecasts, discount rate, cost of servicing, ancillary income, impounds, etc.  MIAC uses these assumptions to establish the value and then compares it to current servicing released market.  If the economic value is higher, a mortgage banker may consider retaining servicing and booking the asset on the balance sheet as purchase servicing.  The present value of the servicing rights takes servicing income and depreciates it over time based on prepayment assumptions.  MIAC conducts ongoing servicing valuations and adjusts the valuation based on deviation from the assumptions. 

After determining it makes financial sense to retain servicing, there is a liquidity consideration that must be addressed.  As noted above, mortgage banker must use part of the servicing value to subsidize the price to be competitive in the market place.  Most mortgage bankers need cash generated from the servicing sales to operate the business and generate profits.  They also don’t have the financial strength to finance acquisition of servicing.

Though it may make economic sense to retain servicing, in the end, it all boils down to liquidity.  Without cash, small mortgage bankers don’t have the ability to retain servicing.  In the past, mortgage bankers retained servicing as a key strategy to generate long term profits and value.  Today only a few can do that. Most are now relegated to originating and selling loans.