What it means
When a bank makes a home loan, it often sells the loan to an investor or packages it into a security. The bank can keep the job of running the loan day to day, which means sending statements, collecting payments, holding money for property tax and insurance, chasing late payers and passing the cash on to whoever owns the loan.
That job, and the fee that comes with it, is the mortgage servicing right. The fee is usually a small slice of the unpaid balance, often a fraction of 1% a year, taken out of each borrower's interest payment.
Because it is paid only while the loan is still outstanding, the asset behaves like a stream of income that shrinks as borrowers pay down or refinance their loans. A servicer that handles millions of dollars of loans can therefore build a dependable fee base without lending a single extra dollar.
Accounting for MSRs is where non-specialists get caught out. The right is recorded as an asset, and its value depends heavily on how quickly borrowers are expected to repay early, which is called prepayment speed (the pace at which borrowers pay off loans ahead of schedule).
When interest rates fall, more people refinance, the loans disappear sooner, and the servicing asset loses value. This makes MSRs a natural partner to the mortgage origination business.
Origination earns more when rates fall and people refinance, while servicing earns less, so firms that do both often use one to cushion the other. Finance teams spend real effort on hedging, which means taking offsetting positions so a rate move does not hurt the whole business at once.
Servicing also carries costs and obligations that appear only when things go wrong. The servicer has to advance payments to investors even when a borrower has stopped paying, and it must follow strict rules on how it treats struggling borrowers.
A portfolio looks very profitable in a calm year and surprisingly expensive in a year of rising defaults.
In practice
Real-world examples.
Example
A regional bank originates $500,000,000 of home loans a year and sells most of them to investors. It keeps the servicing rights, so every month it still collects payments and earns a fee, which gives it income long after the loan sale gains have been booked.
Example
A specialist non-bank servicer buys the servicing rights on a $3,000,000,000 block of loans from a lender that wants to raise cash. The servicer pays a price based on expected fees, hires staff to run call centres and escrow accounts, and makes its return from running the portfolio more cheaply than the seller did.
Example
A finance director at a mortgage company notices the servicing asset on the balance sheet has dropped by $6,000,000 in a quarter even though no loans defaulted. The cause is a fall in market rates that sped up refinancing, so the expected life of the fee stream got shorter.
Formula
Calculation
Annual servicing fee income = Unpaid principal balance x Servicing fee rate
Value of MSR = Annual servicing fee income x Servicing multiple
Suppose a lender services a portfolio with an unpaid principal balance of $200,000,000 at a servicing fee of 0.25% a year. Annual fee income = 200,000,000 x 0.0025 = $500,000. If the market values this stream at 4 times the annual fee, the MSR is worth 500,000 x 4 = $2,000,000. Now suppose rates fall and 20% of the loans are refinanced away, so the balance drops to 200,000,000 x 0.80 = $160,000,000. Fee income becomes 160,000,000 x 0.0025 = $400,000, and at the same multiple the MSR is worth 400,000 x 4 = $1,600,000, a fall of $400,000.Case study
Seen in the real world.
Harbourline Home Finance is an illustrative, fictional lender that services $1,000,000,000 of loans for a 0.30% fee. Its servicing asset is carried at $12,000,000, which is four times the $3,000,000 annual fee income.
When market rates dropped sharply, the finance team expected a wave of refinancing and worked out that about 25% of the balance would leave within a year. That would cut annual fees to $2,250,000 and the asset to $9,000,000 at the same multiple, a hit of $3,000,000.
The firm had also kept an origination arm, which earned extra fees on those refinancings. The illustrative lesson is that Harbourline treated the two businesses as one risk and judged the servicing loss against the new origination income, rather than looking at either number on its own.
Watch out
Common mistakes.
- Assuming that whoever services a loan also owns it, when the owner of the loan and the holder of the servicing right are often different parties.
- Treating the servicing asset as a fixed number, when its value moves with interest rates and prepayment speeds.
- Ignoring the cost of running the portfolio and quoting the fee rate as if it were all profit.
Questions
People also ask.
Can MSRs be sold separately from the loan?
Yes, servicing rights are routinely traded between firms without any change in who owns the underlying loan.
Why do MSRs lose value when rates fall?
Lower rates encourage borrowers to refinance, which shortens the life of each loan and so shortens the period over which the servicer earns fees.
Who pays the servicing fee?
The fee is taken from the borrower's monthly payment before the rest is passed to the loan investor, so the borrower does not receive a separate bill.
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