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1 1 (June 29, 2022)

handle is hein.crs/govehxs0001 and id is 1 raw text is: Con re &on I Re edrch Ser rning ~Ie~ ived. aes~i ~o1A4 June 29, 2022 Mortgage Servicing Assets and Selected Market Developments A mortgage servicer receives a fee to perform various administrative tasks that include collecting and remitting the principal and interest payments made by a borrower to the owner (e.g., lender, investor) of the mortgage asset; managing the borrower's escrow account; processing the loan title once paid in full; and administering loss mitigation (e.g., forbearance plans) or foreclosure resolution on behalf of the lender if full payment is not received. Mortgage servicing assets (MSAs), also referred to as mortgage servicing rights, generate fees reportedly averaging 25 basis points (0.25%, or $250 per $100,000 of an outstanding mortgage balance) per month. This InFocus describes the market for MSAs, recent developments, and issues pertaining to cash flow volatility. Background Just as a mortgage is an asset for the owner, the right to earn income for servicing a mortgage is an asset for a servicer. MSAs have properties similar to other assets. MSAs are traded (bought and sold) in a separate market from the original underlying mortgages. MSA values are based upon the discounted sum of expected future cash flows, calculated based upon the expected cash flows generated by the underlying mortgage itself. An MSA is conceptually similar to a financial derivative in that its value is linked to the performance of an underlying asset. An MSA's cash flows are linked to the cash flows of an underlying mortgage, which typically faces two key timing risks: 1. Mortgages have prepayment risk-the risk that a borrower repays the mortgage early or ahead of schedule, causing the asset to generate a lower yield (return) than initially expected. Declining interest rates increase a mortgage's prepayment risk, causing the value of the linked MSA to decline in anticipation of terminated future cash payments. 2. Mortgages have credit (default) risk-the risk that a borrower pays late or fails to repay the principal and interest obligations. Default risk reduces the cash flows for a mortgage and its linked MSA. Furthermore, the costs to service a defaulted mortgage rise substantially. Servicers' potential profits, known as the excess servicing fees (ESFs), are the difference between the fees charged and servicing costs when borrowers repay mortgages as scheduled without any prepayment or default actions. Servicers purchase the MSAs upfront for the right to receive future cash flows. Because the unpredictability of timing risks increases the difficulty to value MSAs linked to a mortgage portfolio, prospective servicing firms typically place bids on them at auctions. After settling on a price, a servicer may need to borrow funds to purchase the MSAs. One option may be to obtain a cash advance loan that uses anticipated ESFs as collateral. If a rising timing risk causes an MSA's cash flow (and value) to decline, then the servicer would likely receive a margin call, which would require either more collateral to be pledged or the cash advance to be repaid in full. Macroeconomic events (e.g., interest rate movements, rising unemployment) may trigger large amounts of unanticipated prepayments or defaults of mortgages, resulting in no ESF payments and possibly material financial losses for servicers. Selected Regulatory Developments Several regulatory developments following the 2007-2009 Great Recession had MSA market ramifications. Bank Capital Requirements and Implications. According to the Federal Reserve, nonbank servicers purchased a significant share of MSAs beginning in 2011 following bulk sales by large banks in anticipation of the 2013 revisions to banks' capital requirements that increased the cost to hold MSAs. Specifically, if a bank's MSA holdings were valued at less than 10% of its common equity value, a risk weight of 100% would be applied to that amount. The risk-weighted amount would then be used to calculate how much additional capital must be held to absorb any potential credit losses. However, a bank's total capital reserves would be reduced by the value of MSA holdings exceeding the 10% threshold. On July 22, 2019, the federal banking agencies reduced the costs to hold MSAs for non- advanced approaches (non-AA) banks (i.e., defined as having less than $250 billion in total consolidated assets or less than $10 billion in foreign on-balance sheet exposure). Specifically, a non-AA bank's MRS holdings may exceed 25% of its common equity before having to reduce its capital reserves. However, the risk weight for MSAs below the threshold increases from 100% to 250%. After the revisions to banks' capital requirements, the Bank Policy Institute announced that non-AA banks increased their MSA holdings relative to the large AA banks by a statistically significant amount. Consumer Protection Revisions and Implications. Servicers must comply with multiple sets of servicing rules that are designed to establish policies and procedures for borrower disclosures, notifications, and various other protections. The Consumer Financial Protection Bureau (CFPB) found that information about borrowers' circumstances was lost during transfers of delinquent and defaulted mortgages from current servicers to specialty servicers, which specialize in servicing such loans, thus resulting in delayed loss mitigation applications and

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