Capital Confusion at Ginnie Mae & Mortgage Servicing Rights

June 26, 2024 | Updated | Premium Service |  In this edition of The Institutional Risk Analyst, we provide notes and impressions on the IMN mortgage servicing rights (MSR) event in Dallas this week.

The first panel of the event featured a discussion with several issuers, who described how the competitive environment in Ginnie Mae servicing is being impacted by the prospective risk-based capital (RBC) rule that goes into effect at year-end. We wrote about the RBC rule in our most recent comment for National Mortgage News ("Ginnie Mae risk-based capital rule is unworkable").

Ginnie Mae officials seem to be preoccupied with the idea of MSR values suddenly falling when the FOMC cuts interest rates. History suggests that this concern is not well-considered as in 2020-2021, when prepayment rates jumped to 50% in a matter of months. What Ginnie Mae is essentially saying via the RBC rule, which requires issuers to subtract the excess servicing strip (ESS) from capital, is that they’d rather have issuers hold cash than MSRs.

It seems that Ginnie Mae officials would rather have issuers raise the net present value of the MSR in cash today than take the price risk of holding the whole MSR asset through time. The staff of Ginnie Mae do not seem to appreciate that MSR valuations increasingly reflect the value of future recapture of existing customers. As discussed below, the Ginnie Mae RBC rule is actually forcing MSR valuations higher.

Issuers that pay 6x or 7x price multiples for MSRs are doing so because of the proposed RBC rule. Only with assumed recapture rates of 50% of total prepayments do these valuations make sense, but that's tomorrow's problem. Of note, one speaker at the IMN event reported that more auditors are willing to accept the optionality of future loan recapture for the purposes of GAAP valuations of MSRs. This change alone has been forced by the RBC rule proposal by Ginnie Mae and is probably good for a 20% boost in MSR valuations.

Bill Greenberg of Two Harbors (TWO) repeated his view that people are wrong about "stress" on the MSR in a falling rate environment. The scenario that people think is most stressful, namely a falling rate environment, is actually not because there is so much cash sloshing around the system.

The more stressful scenario, says Greenberg, is a rising rate environment where issuers must post more margin on the hedges that they can get in cash from financing the MSR. Since the RBC rule lowers leverage on the MSR from 65-70% to just 50%, the Ginnie Mae proposal will actually increase stress and reduce liquidity for independent mortgage banks.

Scott Buchta from Brean Capital said that in comparison to the massive 2020-2021 refinance wave, today 1% of conventional borrowers and 4% of Ginnie Mae borrowers have 50 bp of refinance incentive in Q1 2024. Thinking about the market today at 6.5% coupons, if we go down to 5.5% on conventionals, it helps.

We need rates to go down 150 bp to really move the needle, Buchta commented. Some 60% of borrowers have rates below 4%. Newer borrowers should be easier, faster and cheaper to refinance. If we get below 6% mortgage rates, that’s when we start to see things pick up. At 5.5% mortgage rates, we start to unlock the housing market and encourage more voluntary sales.

Source: FDIC/WGA LLC

Nolan Turner of Carrington talked about how the proposed Ginnie Mae RBC rule is impacting MSR valuations:

“If you think about how this risk-based capital rule impacts issuers, let’s do the numbers. Everyone that originates loans loses money today. Screen price for a Ginnie Mae 6.5 is 150 bp. That loan costs at least 400 bp to originate. So you sell the loan for 150 bp and you are upside down 250 bp. Even if you put a 4x multiple on the Ginnie Mae MSR, you are still losing money on the loan. The only way to make ends meet is to increase the valuation on the MSR. Did I say a 4 multiple? No, I meant a 5x. Or was it a 6x? I can’t remember. But the point is that the MSR needs to be overvalued to make all of this work.”

Mike Lau of Pingora/Bayview made the point that rising taxes and insurance costs are going to take some issuers by surprise. Higher home prices and related increases in home insurance may even cause unexpected advances for taxes and insurance on these assets, creating obligations that may take months to recover.

Lau ventured that increased costs for insurance is a major unrecognized issue facing lenders in terms of the impact on consumer credit. A reader, however, notes that higher insurance and tax payments mean bigger escrows, which ultimately are good for mortgage banks.

Lau also said that any rate cuts by the Fed will lead to a feeding frenzy in conventionals that will make pricing "very challenging."

Buchta noted in this regard that we are still 200 bp away from a mortgage rate that brings a significant number of loans into the money for refinance. Of note, rate buydowns remain a significant part of the market and the market continues to produce 4.5% and 5% coupons in significant volumes.

Turner of Carrington noted that consumers are facing a lot of stress due to inflation. He said that we are seeing a "rinse & repeat" cycle in distressed servicing where borrowers fail modification multiple times. He notes that some 40% of Ginnie Mae loan mods are going into redefault, illustrating the true level of stress affecting many households. Turner says that households below $150k income are showing particular levels of distress. Taxes and insurance have doubled, forcing up DTI ratios.

Also, Turner notes that he expects to see strategic defaults as and when home prices begin to fall. He says that many of the prepays seen now reflect sales by troubled debtors that finally took the equity off the table after multiple failed modifications. Sales were 20% of prepays before COVID, but now outright sales are more like 70% of total prepayments.

As long as the equity in the house is positive, Turner notes, borrowers can essentially fund the loan modifications with their own equity. When the equity declines or disappears, however, the visible cost of default will rise proportionately and actual foreclosures will grow. FHA and VA programs to modify borrowers to below market rates will help, but the low income consumer is taking a kicking due to inflation in the current economy.

Jeff Lown of Cherry Hill Mortgage Investment Corporation (CHMI) noted that last time prepayment rates (CPRs) went to 50% in 2020, it took four months to get there. Next time it will take 45 days because of changes in technology. Something for us all to look forward.

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