When interest rates began skyrocketing more than two years ago, mortgage companies faced a pivotal decision regarding a crucial part of their business: the servicing portfolio.
This period was a windfall for servicers. Rising rates typically slow down borrower prepayments, increase the fair value of mortgage servicing rights (MSRs), and enable companies to earn more interest on funds held in escrow accounts.
The dynamic has led to a repositioning of players in the market. Many independent mortgage banks opted to sell a substantial portion of their MSRs, aiming to free up cash and stay afloat amidst declining origination activity, anticipating future regulatory capital requirements or simply lacking interest in maintaining these assets.
Conversely, other companies seized the opportunity to expand their portfolios, securing the future right to get the inside track on refinancings when rates eventually drop. In the meantime, these companies could market other products, such as home equity loans, to borrowers in these portfolios.
Now, with the Fed expected to lower interest rates at its upcoming September meeting, which could bring down mortgage rates, the strategies lenders have implemented over the past two years will be put to the test.
“Rate declines will impact companies differently based on their business model,” said Craig Freel, partner and co-chief investment officer at Rice Park Capital Management, an investor in residential mortgage assets.
According to Freel, originators that do not own MSRs are likely to benefit from lower rates due to higher origination volumes and the absence of markdowns on their servicing books. However, originators with large MSR portfolios may face challenges, as the value of their MSRs will decrease when rates drop.
There is a caveat: “What we’ve seen of most large-integrated operators is that they have become much more successful at focusing on recapture. That will offset some of the losses. Also, many large firms now hedge either all or a portion of the interest rate risk, something that has changed over the last 10 years. So, they are positioned better to handle it.”
In recent weeks, HousingWire has listened to mortgage lenders’ second-quarter earnings calls, reviewed analysts’ comments and interviewed industry experts to address a critical question: From a servicing perspective, which companies are best positioned for the new rate cycle?
“A sticky Rolodex of relationships”
No company exemplifies the strategy of acquiring MSRs at higher coupons to offer refinancings when rates drop better than Mr. Cooper Group. Analysts have called the company a servicing “powerhouse,” after it acquired Home Point Capital’s $84 billion servicing portfolio in May 2023 and Flagstar’s $356 billion book in July 2024.
As of June 30, Mr. Cooper had become the largest U.S. primary servicer—those companies with direct consumer interactions, regardless of who owns the servicing rights—with a $1.2 trillion unpaid principal balance (UPB). The company is expected to reach a UPB of $1.5 trillion once the Flagstar deal closes. Additionally, Mr. Cooper ranks as the fourth-largest holder of MSRs, considering both whole loan portfolios and servicing rights, with $676 billion at the end of June—an increase of 70% over two years, according to Inside Mortgage Finance.
The company’s focus is to capitalize on its 6.6 million clients, a number it will likely reach by early 2025 after migrating Flagstar’s customer base. Mr. Cooper estimates it will hold about $132 billion in mortgages at 6% or higher once the acquisition is finalized.
But acquiring these clients is only part of the strategy. Mr. Cooper must maintain high retention rates to drive more business, an achievement that requires investment in technology and product development. In the second quarter of 2024, the company’s refinance recapture rate stood at 72.5%, positioning Mr. Cooper to add tens of billions in origination volume when rates fall below 6%.
“We expect most of the [Flagstar] purchase price is ascribed to the owned MSRs, although we also see value in a sticky Rolodex of relationships in the Flagstar subservicing portfolio,” BTIG analysts Eric Hagen and Jake Katsikas said in a report. They noted that the deal “adds to Mr. Cooper’s significant scale, making it the top servicer over JPMorgan Chase.”
Like Mr. Cooper, Freedom Mortgage has also demonstrated a strong appetite for higher-coupon servicing assets. In September 2023, the company raised $1.3 billion in debt. According to IMF estimates, Freedom Mortgage’s primary servicing portfolio grew by 23.5% over two years, reaching $523 billion by the end of June, while its owned portfolio increased by 34% to $589 billion in the same period.
“The credit today is probably the best we’ve seen,” Stan Middleman, founder, president and CEO of Freedom Mortgage, said. “We’ve taken the opportunity to exercise our access to the capital markets, and raise a lot of money to ‘buy customers’ in bulk or in flow. And we really think we’re gonna have these customers with us for a really long time. That’s our goal.”
Middleman pointed to average loan-to-value ratios of 50%, average debt-to-income ratios in the low 40% range, and credit scores in the low 700s as indicators of an “extraordinary” credit.
Rocket Mortgage has also begun to expand its servicing portfolio. The company, ranked as the No. 8 primary mortgage servicer in the U.S. per the IMF ranking, acquired five portfolios totaling $21 billion in UPB in the second quarter of 2024.
“The note rate on these portfolios are above Rocket’s current portfolio weighted average coupon because Rocket has shown a preference for acquiring near- or in-the-money servicing portfolios,” Jefferies analysts Derek Sommers and John Hecht said in a report.
Varun Krishna, CEO of Rocket Companies, told analysts during an earnings call in early August that the retention machine is working since the company is “retaining clients for the next transaction at rates three times higher than the industry average, positioning ourselves as their lender for life and generating recurring cash flow without additional acquisition costs.”
When servicing can be a ‘drag’
A side effect of lower rates is the reduction in the fair value of MSRs, an accounting effect that can weigh down companies’ earnings. Some companies attempt to offset this impact with stronger origination performance and by hedging their servicing assets. For Newrez, owned by Rithm Capital, analysts expect that this strategy will yield positive results in the coming quarters.
Newrez’s primary servicing portfolio grew by 49% in two years, reaching $741.6 billion by the end of June 2024, placing it fourth in the industry. Its owned portfolio increased by 7% during the same period, reaching $596 billion, making it the sixth largest, according to IMF data.
Although Rithm executives assert that the company is not aggressively pursuing servicing growth, it did engage in acquisitions, notably adding $154 billion in UPB from Specialized Loan Servicing after a deal closed in May.
Currently, most of the company’s servicing portfolio – 96% to be exact – is out of the money for refinancing, with a weighted average coupon of about 4%, well below production level. The prepayment rate stands at 6.2%, and the company is bolstering its hedging strategies to protect these assets.
“Our earnings estimates are under review, but even with significant growth in the servicing portfolio, we roughly expect upwards of around $50 billion of originations over the next 12 months should still replace MSR runoff between 6-9 in conditional prepayment rate,” BTIG analysts noted in a report. “At much lower rates we think MSR amortization risks being a bigger drag, but at its current size/leverage we’re not looking for quarterly amortization to breach $200 million, or $0.40/share.”
Pennymac is another nonbank working to safeguard its servicing book. As of the end of June, its owned portfolio stood at $632 billion, marking a 20% increase over the past two years.
William Chang, senior managing director and chief investment officer at Pennymac, said the company’s hedge strategy is designed to minimize earnings volatility and enable borrowing against its MSRs. Hedge gains help to offset the decline in fair value decline and cover margin calls if necessary, he added. Pennymac considers “basically 125 basis points higher and 125 points lower” when planning its hedging strategy, Chang said.
Jefferies analysts Sommers and Hecht highlighted another advantage for Pennymac in the upcoming business cycle: the company’s multi-channel strategy.
“PFSI has $113 billion in UPB in its servicing portfolio of mortgages with above 6% note rates, which was mostly procured through the lower margin correspondent channel,” the analysts said “These loans will be refinanced through its higher margin direct-to-consumer channel.”
Who’s on the opposite side?
If servicing can provide some gains when rates drop, why have some companies strategically chosen to sell these assets? Freedom Mortgage’s recent plays offer insight.
“We’re buying from different people that need to raise cash for operations, or just to get into some stability or just to take some risk off the table, whatever the case is,” Middleman said. “At the end of the day, there was a lot of servicing accumulated throughout 2020, 2021 and 2022, and some of that has paid dividends along the way, and now they’re [sellers] taking the opportunity to get high prices, and we’re paying high prices because we like the product.”
One company that has opted to sell is California-based loanDepot, which has been dealing with financial losses. According to IMF data, loanDepot’s owned servicing portfolio declined by 26% over two years, reaching $114 billion in UPB as of June. Recently, the company sold a significant portion of its MSRs, primarily from low-coupon originations from the 2020 and 2021 vintages.
“We opportunistically took advantage of strong market conditions and monetized approximately $29 billion of unpaid principal balance of our mortgage servicing rights,” David Hayes, loanDepot’s chief financial officer, told analysts.
While selling MSRs can boost earnings in the short term, it has long-term consequences. “As a result of the smaller portfolio, we expect servicing revenue to decrease somewhat going forward. We hedge our servicing portfolio, so we do not record the full impact of the changes in fair value and the results of our operations. We believe this strategy protects against volatility in our earnings and liquidity.”
To counterbalance this, loanDepot has also been gradually increasing its number of loan officers and enhancing its operational capabilities to capitalize via mortgage origination on a lower-rate environment in the future.
Another active seller in the MSR market is Pontiac, Michigan-based United Wholesale Mortgage (UWM), the country’s largest originator. UWM executives have strategically sold higher-coupon MSRs to deleverage the company’s balance sheet and reinvest in its origination business. The company is confident that its network of brokers will drive business growth when mortgage rates decline.
Mat Ishbia, chairman and CEO of UWM, said in a call with analysts that when rates drop, lenders will get flooded with refinances because trillions of dollars of loans were originated in the 6.5% to 8% range. Volumes will increase, as will gain-on-sale margins. In turn, “MSR write-downs will be massive,” he added.
“Obviously, nobody controls the MSR write-ups and write-downs. We never take credit when it goes up. We don’t want to take credit when it goes down. We want to focus on origination,” Ishbia said. “For us, we don’t buy MSRs, we originate them. I don’t see a slowdown in people buying MSRs because that’s the only way they can originate.”
Analysts note that UWM has performed well in the purchase-oriented market that emerged in the second half of 2022. As evidence of this, the company is currently the top mortgage lender in the country. During this period, UWM’s management has invested in tools and technology to enhance broker capacity, positioning the company to maintain its market share in the event of a refinance boom. To further support this, UWM is offering incentives on some refi loans.
Banks vs. nonbanks
Analysts widely expect banks to scale back their involvement in mortgage servicing due to increasing regulatory pressures. The forthcoming Basel III Endgame rules, slated for publication early next year, are anticipated to raise capital requirements for holding these assets, making them more costly to maintain. A sign that a pullback will occur is in UBS Group AG‘s recent decision to sell Credit Suisse’s mortgage servicing company, Select Portfolio Servicing (SPS), to a group of investors led by Sixth Street.
The most significant move in the space, however, comes from Wells Fargo. The bank has elected to exit the home lending correspondent channel, reduce its presence in residential mortgage servicing and sell off most of its commercial servicing assets. Once the leader in the primary mortgage servicing market, Wells Fargo was the third-largest player by the end of June, with $771 billion in UPB, trailing Mr. Cooper and JPMorgan. Its owned servicing assets have dropped by 21% over the past two years to $769.2 billion, positioning it second after JPMorgan.
Competitor JPMorgan took the crown from Wells Fargo, with a $977 billion owned servicing book as of June, up 17% in two years. In the top primary mortgage servicers ranking, it was the second largest after Mr. Cooper, with $949.8 billion in UPB as of June, up 20% in the period.
However, it would be a mistake to assume that banks are retreating entirely from the servicing sector. As of the end of June, depository banks made up four of the top 10 firms in owned mortgage servicing—JPMorgan Chase, Wells Fargo, US Bank Home Mortgage, and Bank of America—though their collective market share in UPB has declined by five basis points to 42% over the last two years. Among the top 10 primary mortgage servicers, banks’ share increased by three basis points to 30%, with JPMorgan, Wells Fargo, and Flagstar featured prominently.
Regulators, meanwhile, may be favoring depositories with their recent moves. A recent report from the Financial Stability Oversight Council (FSOC) highlighted vulnerabilities at nonbank mortgage servicers, warning that these could pose risks to financial stability. The FSOC recommended increased regulation and measures to bolster these companies’ liquidity during periods of stress.
Additionally, Ginnie Mae’s new risk-based capital requirement—effective December 31, 2024—poses a significant challenge for nonbanks. While it reduced the minimum risk-based capital ratio from 10% to 6%, it also imposed a 250% risk weight on MSR assets and mandated a dollar-for-dollar deduction from capital for excess MSRs.
“When we talk about companies getting as large as some of the largest nonbank servicers have gotten, there certainly needs to be an evaluation of what are the risks of that company not being able to function in the market, and what happens to the underlying consumers,” Rice Park’s Freel said.
