Reengineering the Secondary Mortgage Market for Better Risk Management

1
Re-engineering the Secondary Mortgage Market for
Better Risk Management

• Michelle McCarthy
• SVP, Corporate Market Risk Management
• Washington Mutual Bank
• May 19, 2004

2
Overview

• The case for change in the mortgage market
• The risk management challenges posed by the
  mortgage servicing right asset (MSR)
• Comparing MSR to an IO
• Hedging tradeoffs for MSRs
• What market changes can affect the MSR?
• What would the impacts be on lenders and
  investors?

3
The case for change

• Continuing growth in mortgage market
• Continuing consolidation among mortgage servicers
• Concentrates MSR asset
• Asset must be capitalized
• Behavior similar to an IO
• Requires complex hedging, can be capital
  intensive

Resolving these pressures in the secondary market
could avoid dislocations in the primary market
4
Case for Change Continuing Growth in the
Mortgage Market

• State of the Nations Housing
• Harvard Housing Center reported that U.S.
  households will increase 22.6 to 129 million in
  the next 20 years or 1.19 million new households
  per year

It is clear that the underlying demographics
will (drive) the housing market - Nicolas
Retsinas
Source State of the Nations Housing report,
Harvard Housing Center, June 2002.
5
Drivers of Growth Projected Single-Family
Mortgage Debt Outstanding
Actual(a) Forecast
Range(b) 1980s 1990s 2001-2010 Households
1.5 1.3 1.2 - 1.3 Homeownership Rate
(0.2) 0.5 0.3 - 0.4 Average Home Price
Gains 7.3 3.9 5.0 - 6.5 SF Residential
Investment 8.6 5.7 6.5 - 8.2 Debt-to-Valu
e Ratio 2.0 1.4 1.3 - 1.7 SF Mortgage
Debt Outstanding 10.6 7.1 8.0 - 10.0
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Mortgage Origination Market Trends
Steady Projected Growth
3.8
8.0 Purchase Market CAGR
2.6
2.5
2.0
2.0
1.5
1.3
1.0
0.8
0.8
0.8
0.6
Source Mortgage Bankers Association, Mortgage
Finance Forecast, April 2004
7
Case for Change Continuing Growth in the
Mortgage Market
Mortgage Debt Outstanding
Source Board of Governors of the Federal
Reserve, Flow of Funds Accounts, 2003 data
through Q2
8
Case for Change Continuing Growth in the
Mortgage Market
Debt Securities Outstanding Market Share
Source Bond Market Association 2003 data
through Q2
9
Case for Change Continuing Consolidation Among
Mortgage Servicers

• Mortgage Servicing Market Trends

in trillions
8.5 CAGR
10
Accelerating Consolidation in the Mortgage
Industry
Case for Change Continuing Consolidation Among
Mortgage Servicers
Top 10 Market Share
Source Inside Mortgage Finance April 30, 2004
(Originators) and May 7, 2004 (Servicers).
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The Challenges of the MSR asset

• The IO market that dwarfs other IO markets
• Base excess servicing capitalized
• Market value moves strongly for changes in
  interest rates
• Mortgage servicers can be a strong factor in the
  hedging markets after large interest rate
  movements
• The perfect hedge eludes, requiring heavy
  activity
• The larger the servicing fee is relative to cost
• Activity shifts away from performing a service
  for a fee
• Activity shifts to managing a complex IO portfolio

Large concentrations of this capital-intensive
asset across a limited range of participants
could affect the growth of the mortgage market
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How is an MSR similar to an IO?

• Strip of expected cashflows related to an
  underlying set of mortgages
• Subject to prepayment risk
• Likely to prepay in low rate environments
• Duration lengthens in high rate environments
• Value change, in percent terms, very large for a
  given change in rates
• Relates to the unpaid principal balance of the
  underlying mortgage loans
• Hedge buy duration

13
How is an MSR different than an IO?

• Need a mortgage servicing plant in order to own
  MSR
• Items other than interest rates, prepayment
  speeds affecting value include
• Costs to service
• Ancillary income (fees, etc)
• Earnings on certain balances
• Timing of mortgage payoffs, tax and insurance
  payments
• Other items
• Every securitized mortgage creates an MSR
• IOs are created for a much smaller subset of
  mortgages that underlie Collateralized Mortgage
  Obligations

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Two sources of larger than desirable IO

• Base servicing fee arguably too high
• MBS trading in 1/2 point coupons

15
Servicing is an Operating BusinessNot a
Derivative Investment

• Base service fee in current operating environment
  is too high
• Unit costs have decreased with scale and
  technology
• Expenses are based on units
• Revenue has increased
• Based on loan size
• Contribution of non-service fee income -
  ancillary float

Result Margin between revenue and expenses has
created a larger absolute MSR value, and has
expanded the role of servicers to investors in IOs
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No Viable Secondary Market Outlet for
Additional Premium

• Agency MBS market is the only fixed-income market
  that trades in 1/2 coupons
• As a result, the bulk of the market for the past
  two years is in 6s and 6.5s last years recent
  refi boom produced 5s and 5.5s
• Mortgages are slotted into closest coupon,
  buying up or buying down
• Buying up avoids excess servicing but is often
  uneconomic
• Buying down creates excess servicing

Result Lenders create relatively large excess
servicing (IOs) that they capitalize and hold
17
What changes in mortgage market would improve MSR
concentration?

• Reducing servicing fees
• 1/4 or 1/8 coupons
• Excess servicing sales

18
Reducing servicing fees

• 10-15 bp servicing fee instead of current 25
• Align servicing fee with the costs and income of
  servicing
• Strike a balance between risk/reward and market
  requirements - the lenders skin in the game
• Recent moves
• GNMA II from 44 bp to 19 bp
• Fannie Hybrid _at_ 12.5 bp
• Freddie Hybrid _at_ 10 bp
• The time is right for a thorough review

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Trading in 1/4 or 1/8 coupons

• Mortgage originators price their loans to
  consumers in 1/8s
• An MBS market that traded in 1/4s or 1/8s would
  allow originators to sell their excess
  servicing and book cash gains
• Diffuse the risk
• couple with original security,
• distribute across capital markets rather than
  concentrating among servicers
• Issue perceived liquidity risk
• Supply is in the trillions
• CMO bid a natural buyer

20
Excess servicing sales

• Countrywide and Washington Mutual have executed
  transactions selling excess servicing to the
  capital markets
• FN Trust 309, 325, 330, 331, 335 and 336
• Appeals to the more limited set of IO investors
• 1/8 or 1/4 coupons bring this same cashflow to a
  wider set of investors

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Conclusion

• It makes sense to concentrate servicing
• Cost reduction and increased efficiency through
  scale
• But it doesnt make sense to concentrate and
  magnify the ownership of IOs
• As the mortgage market grows and the servicers
  consolidate, every extra basis point in an MSR
  leads to avoidable risk concentration
• If lenders, investors and all other interested
  parties can agree changes to right-size the value
  of MSRs, it will remove unnecessary volatility
  and can ultimately benefit borrowers