The mortgage servicing rights (MSR) market has been very active this year, with robust deal flow that is on par with last year’s record $1 trillion in trading volume and with generally good pricing for MSR packages, industry experts agree.
A fly in the ointment, however, particularly for some independent mortgage banks (IMBs), is the elevated risk of agency loan-repurchase demands — triggered by loans that violate Fannie Mae’s or Freddie Mac’s rep and warranty policies due to some defect discovered during the agencies’ post-origination quality-review processes.
Industry players who spoke with HousingWire agree that the level of repurchase demands has increased this year and that is having an impact on some buyers and sellers of MSRs. They also stress that agency repurchase demands are not negatively affecting the overall volume of MSRs sold — or prices paid for the MSRs, in most cases.
On the margins, though, particularly with smaller struggling lenders, repurchase risk can result in more loans being excluded from MSR pools offered for sale. In addition, the risk of agency buyback demands also can affect the structure of MSR deals — to account for rep and warranty liability exposure.
“There is a lot of money chasing MSRs,” said Mike Carnes, managing director of the MSR valuation group at Mortgage Industry Advisory Corp (MIAC). “We’re seeing good multiples [a measure of pricing on MSR pools], like 5.5 multiples and some 5.6s, which historically is a good level.
“I would say by and large, you know, we haven’t seen those kinds of prices since prior to the [global] financial crisis]. There’s solid demand, and the levels that are being paid are attractive, so one might argue that it would be a good time to sell the MSRs.”
Alan Qureshi is managing partner of Blue Water Financial Technologies, a technology-solutions provider for the secondary mortgage market offering mortgage-servicing rights (MSR) and whole-loan pricing, trading and risk-management services. He agrees that the high end of pricing for MSRs now is in the 5.5 multiple range “for pristine deals … and you might even be able to get a bit higher.”
He also stressed that the elephant in the room is agency loan-repurchase demands.
“On the smaller (MSR) deals, it’s going to be south of that [5.5 multiple] depending upon the characteristics [of the loan pool], and front and center is that [loan] buybacks are the big risk in the marketplace.
“And if you’re an asset-based investor [an MSR buyer], one of these buybacks can absolutely destroy your return.”
In terms of agency loan-repurchase demands, the entity acquiring the servicing will be either first in the waterfall of liability or insulated from that liability, depending on how the MSRs are acquired.
“The fact that we’re seeing the increase in repurchase demands is a function of just what the [origination] volumes were [in 2021 and 2020],” said Tom Piercy, managing director of Incenter Mortgage Advisors. “And the agencies are now trying to claw back and wanting to set up some reserves on their end.”
In co-issue MSR sales through agency platforms, Piercy added, bifurcation of the rep and warranty liability is provided, which keeps the loan originator (the seller of the loan to the agencies) in the prime position in terms of repurchase liability. With bulk sales of MSRs handled outside the agencies, however, bifurcation is generally not available and the entity acquiring the MSRs will likely be on the hook.
“The bifurcation then takes that [first-recourse liability] away [from the MSR buyer] …,” Piercy said. “So, under the bifurcation, Fannie and Freddie then will go to the [loan] originator.”
Joseph Grimes, senior advisor to Blue Water Technologies and former vice president of third-party risk management and MSR financing for Fannie Mae’s single-family business, said prior to the global financial crisis, the buyer of the servicing remained second in the liability waterfall behind the seller, “but these programs ceased to exist after [after the agencies were put into] conservatorship.”
Still, agreements between the government-sponsored enterprises (GSEs) and the industry are open to interpretation and mission creep over time, it seems.
Pete Mills, senior vice president of residential policy and strategic industry engagement at the Mortgage Bankers Association, says the organization’s leadership has been meeting with Fannie, Freddie and FHFA executives over the repurchase issue, and those conversations are ongoing. The main concern MBA has with loan repurchases, he explained in a prior interview, is with how the “rep and warranty framework” — worked out years ago between FHFA and the MBA — is being applied in the repurchase process.
“It’s not a new framework [that is needed]. It’s a reset on how the GSEs are implementing it [the existing rep and warranty framework].”
Piercy said savvy MSR buyers have instituted “counterparty diligence forever,” adding that regardless of the repurchase environment, that counterparty review [due diligence] “is critical.”
“Without question, the increase in [agency loan] repurchases is being felt across the industry,” Piercy said. “Is it affecting the MSR market?
“I would argue that I don’t think it is because every buyer that I work with has a pretty stringent counterparty review. … If you [as an MSR seller] push the edge of the envelope, I’m probably going to walk away [from the deal].”
Nick Smith, founder, managing partner and CEO of Minneapolis-based private-equity firm Rice Park Capital Management, an active MSR buyer, said MSR deal flow so far in 2023 “is still very strong … it’s elevated.”
But Smith agrees that loan-repurchase risk is a threat that remains front and center this year for buyers of MSRs.
“One, that’s because the level of repurchases is up and, two, because some of the sellers [i.e., smaller struggling IMBs] are not terribly strong counterparties,” he said. “So, for both of those reasons, yes, as a buyer, it’s something that you have to be mindful of, and it does affect how you transact [business].
“… “If you’re buying assets from a seller who doesn’t have financial stability or strong wherewithal, then the buyer oftentimes will structure the deal in a way that they don’t take on that liability.”
Smith added that the repurchase risk can be dealt with by a seller in a number of ways, including putting funds in escrow to cover pending buyback demands or working with the agencies in advance of the deal to pay off pending repurchase liabilities.
“This [repurchase issue] tends to affect the smaller IMBs, not the bigger ones, so it doesn’t really affect the volume [of MSR sales market-wide] that much because they [smaller IMBs] don’t have that much to sell,” Smith added. “I think it limits their [smaller IMBs’] options and reduces the price that they get.”
Azad Rafat is senior director of MSR services at Mortgage Capital Trading (MCT), which provides advisory and brokerage services primarily for smaller MSR deals — typically less than a $1 billion.
He said MCT has not yet seen the elevated repurchase risk affecting pricing of the MSR deals his firm touches or causing deals to be scuttled. He added, however, that buyers are very focused on due diligence of the MSR packages being offered, “and buyers can identify potential risks and probably will eliminate those loans” from the sale package.
“We did experience, not from the pools we sold or brokered, but we did see some clients that sold loans, and they had to take a few loans out of the pool that they already sold because of credit risk,” he added. “Traditionally, buyers will hire a company that specializes in due diligence, and those companies will pick randomly 10% or 15% of all the loans [in the MSR pool] and look at the documents to make sure everything up to par.
“If there is a risk, then they will expand that due diligence to see what else is there, and that’s how buyers protect themselves. Unfortunately, sometimes things fall through the cracks and get missed, but it’s not detrimental to the entire transaction, though it could be to a small portion of it.”
Rice Park Capital’s Smith agrees that there are ways that repurchase risk can be dealt with short of scuttling an MSR transaction.
“If it’s a strong seller, then the liabilities will just flow through to the buyer who will take on that risk because [they’re confident they’ve adequately] underwritten the risk of the seller,” he explained. “But if the seller is weak [such as a struggling IMB], then they might resort to some other structure that reduces that risk.
“I do think that big [MSR] buyers, ourselves and others included, are much more aware of this [repurchases] as a risk and are thinking about that in terms of the people that they’re willing to buy assets from and the price they’re willing to pay.
“If it’s a small seller selling to a buyer and the buyer is worried about the seller, the buyer also may just say I’m not buying it from you — I’m not transacting with you —because I can’t understand what the risk is here, so I’m just going to back away.”
Correction: The explanation of the flow of rep and warranty liability in agency co-issue sales provided in the original version of this story has been updated — to make clear that the buyer of MSRs is not now part of the liability waterfall post agency conservatorship.
