Lykken on Lending

As the mortgage servicing industry continues to evolve and adapt to new challenges and opportunities, it’s important to stay informed about the latest trends and developments. In the episode, Seth Sprague of Richey May will be discussing the servicing trends and how it is impacting the mortgage industry in these times.

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Servicing Trends With Seth Sprague Of Richey May

Joining Mark and me on the show, Seth Sprague of Richey May. He is the Head of Consulting Services at Richey May and has been doing so since May 2022. Before that, he was one of the principals at STRATMOR. He was there from 2019 to 2022. Previous to that, he was the Executive Vice President at Phoenix Capital. This is an individual that has an extensive servicing background, many years at it. I’m excited to have him here. Seth, welcome to the show.

David and Mark, it’s great to be on the show with you. When we were at Lenders One together, I’m glad we were able to pull this off and get back on the show.

Seth, given all your knowledge and experience in the mortgage servicing area, what’s going on in the market? What are the macro trends in the servicing area, especially when it comes to released or retained?

The trend now is it’s interesting time, given where we are with the origination space and the challenges of low volume and low margins. As we are here in early April 2023, it looks a little bit more like we’ll have a spring season and a summer season. The news is that folks are thinking again about retaining servicing and the customer relationship.

For those that did retain servicing in 2020 and 2021, they certainly enjoyed some great cashflows off their servicing at the experience in 2022. Increasingly, what we’re seeing is companies are realizing that the value of the customer relationship from a long-term perspective is beneficial to not only their origination business but also their cashflows.

Seth, with a recent announcement by FHFA about the servicing and having to be able to continue for those who qualify for deferment of payments due to hardship, what is that going to do? Has that changed in your perspective? Who will be selling the servicing release?

It certainly is an interesting announcement by the FHFA on hardship and several months of forbearance with the tack on the mortgage at the end. I always like to highlight a couple of things about forbearance. It would be a fine part to put in the waterfall of loss mitigation. We have to be somewhat judicious about tacking on principle at the end of the payment.

Under the CARES Act and COVID, it worked great. Property values were increasing 20% a year, and borrowers missed payments and came out of missing payments with more equity. I do have some fears that forbearance, in general, if you’re not experiencing rising property values, could create some stress and strain for those borrowers. It’s a critical element in the waterfall.

As far as changing the liquidity, it certainly changes the cashflows. All of a sudden, a borrower, as long as they’re making qualified contact with their servicer, I want to emphasize that. It is important that those borrowers are talking to their mortgage servicer and they’re walking through what that hardship is so they can get them to the best position.

If forbearance is the position that gets them to stay current, it’s a wonderful solution. I’m not sure it’s a solution that will work for all and work for all in all circumstances. In particular, if we have declining property values in a market, that forbearance may hurt the borrower because they can potentially be losing equity as opposed to a more real-time solution.

Seth, when we discussed this in the show, we were focusing on three things. I’d like you to opine to them if you don’t mind. The first thing we focused on was what was produced in the media. There was no idea what qualified. It says if they qualify. We don’t know if it’s what qualified their COVID-19 or not.

The second thing was they talked about tacking the payments on the end. They don’t say who’s going to bear the burden of any interest accrual on that because they said they’re tacking the payment on the end without any interest accrued on it. They got that. You brought up this third thing, which is important. Everybody’s not created equal.

In that respect, when people are doing this, do you think the borrowers might treat it like a negative loan was a couple of decades ago, and that negative payment on the end, if it takes away some of its equity, might entice them to walk away from it rather than pay out their commitment as they move on through the loan and get in hardship times again?

It presents the danger that a repeat person who goes through that process could end up with a large balance and a negative amortization or a negative equity position, which certainly could lead to them potentially walking away from that mortgage. With the qualification of this, I’m hoping that we get some clarity as to what that means because this is automatic. It is not where the industry wants to go. It needs to be part of that waterfall.

We all know that foreclosures and kicking people out of homes are not what we’re trying to do, but we have to realize that servicers who are in a position of having to advance or, in some cases, get missed payments, when you jump from payment 12 to 19, you lose that servicing revenue. You never earn it back. The more we burden those servicers with those costs, it’s only going to increase the overall cost of mortgages because part of that MSR value, whether you sell it through an SRP or capitalize, is part of the gain on sale calculation. Higher expenses mean higher rates to consumers. What we’re trying to avoid is adversely selecting or having costs to borrowers go up, but servicing costs are going up. Therefore, MSR values don’t increase with such an announcement.

Servicing Trends: When you jump from payment 12 to 19, you actually lose that servicing revenue and you never earn it back.

Seth, how does the origination environment that we’re experiencing impact the servicing side of our business on a go-forward basis?

The easiest way to describe it is it depends on the solution, on that company, and on where they’re at in the cycle of cost-cutting on the origination side and balancing their servicing. A lot of the customers who I deal with here on Richey May have retained servicing and speak to how wonderful the cashflows that they’re producing, which they’re using to offset some origination expense now. Others have said, “I needed to get a war chest of cash in 2022 to help fund the projected losses on origination.” They sold servicing.

We’re in that interesting state where flexing from people looking to sell servicing for cash to go, “I’m going to be cash positive here, if not by March 31st, 2023, certainly in the second quarter of 2023, which gives me the opportunity to start retaining servicing.” The critical question is what servicing do they retain and what do those cashflows look like?

Companies that blanketly retain servicing are going to start looking at the risks of the servicing that they’re going to retain and release. They are doing a lot more analytics around it than taking every other loan or setting some general rules. There is going to be a lot more analytics thrown at what gets retained in this next cycle.

I find that comment interesting since I developed a model that does that for advertisement, Seth. One follow-up question to that, if I could. It’s one thing to talk about retention of servicing. What are you seeing in the market? This question has come up a little bit, and I haven’t been in touch with but is it a buyer’s market or a seller’s market in servicing?

It’s shifted a little bit to being more of a buyer’s market at this point, where buyers are dictating the terms. 2022 was a record year in terms of unpaid principal balance brought to either the co-issue or the bulk market. There was a little bit of buyer fatigue. From a buy side, what you’re seeing change is the counterparty strength and the deal size. For example, if I could do one $10 billion deal with a company that I’m comfortable with their financials or do five $2 billion deals, there’s a market differentiation in terms of the size of the deal, the number of bidders, and the execution.

For example, it’s rumored that Wells is selling servicing. Wells is viewed as a completely different counterparty than even a large independent mortgage banker. Therefore, they may attract a premium price due to the deal size and potential for different deals. The real issue that some of the sellers are facing is a one-and-done seller. They’ve retained a chunk of servicing and want to sell it. They may retain more in the future. Those parties get a lot closer to due diligence. Some of the buyers don’t bid as aggressively on those deals because it’s a one-and-done. You have to put all the plumbing in place, and they’d rather get a more consistent seller in their stable than a one-and-done seller.

You’re saying you think that, for people in their market, if they’re going out to do that one and done, they’re going to be probably stressed a little bit more to get the price they want out of it potentially because somebody might be looking at bigger deals, they’re bringing more loans at once, or somebody with more established selling.

They’ll either get less participation or less aggressive bids, either one of which means they’re not going to get that same value. I’m going to emphasize again. The servicing cashflows that they’ve got in 2022 are phenomenal. They may not be achieving those values because the bidders, regardless of the counterparty, don’t believe prepayment and delinquencies could stay that slow for the life of the cashflows.

Let’s face it, we all know in this call, but 2020 and 2021 production is a few years old at this point. You’ve chunked through some of the strongest cashflows. That loan is amortizing at a different rate due to its low interest payment. Even on a 30-year loan, a larger portion of even the first three years of cashflows are principal than at 6.5% or 7% mortgage rate. Even though you’re a few years into the cashflows, you might be 50% into the expected life of those cashflows already.

As we look at where we’re at as an industry, what areas should companies that service or may get into servicing be aware of that will make a difference in 2023 and that’s different from 2022?

There are a couple of things. One is understanding those cashflows and what natural decay is doing to their servicing fee income.

Explain it to those who don’t understand servicing. When you say natural decay, let’s put a little construct around that.

Natural decay is that amount of principle that’s with every payment. As I refer to it in my terminology, it is that loan chunks down due to the natural payments over time. Those lower WAC loans have a higher principle component than interest component than we traditionally think of over a 6%, 7%, or 8% mortgage.

Understanding the cashflows, how they look over time, and their declining over time is important. The other element that we continually hear across our client base is escrows. What is the value of escrows on those T&I payments that you can earn potential float on? Are you earning the float on it? Are you getting all those cashflows that you can from escrows? Banks have a natural ability to earn to that full float. IMBs tend to have to put those deposits either with a warehouse lender or an MSR financing company. They may not achieve the same value that’s present in the cashflows that are generating that fair value. Those are the two items to be aware of.

The other piece that has been a concern that’s going on now is escrow shortages. Due to those rising property values over time, most people are going to be short escrows. That’s the cash the servicer has to advance. As we talked about already, the origination business and gain on sales are not that strong now. It’s another cash outlay that’s going to occur.

Going forward, property values probably aren’t going as much as they were. We’ll have less of that in the future, but we’ll have rising delinquencies, which will also cause escrow advances. It’s understanding your risk on the cash side of servicing. Are you cash-positive or negative? That is what I’m trying to emphasize to folks.

Servicing Trends: Property values probably aren’t going as much as they were. Even though there will be less of that in the future, rising delinquencies will also cause escrow advances.

What are you seeing in your consulting side of the businesses happening to delinquency ratios on the loans during that period when they were 2.75% to 4%? Are you seeing that delinquency rates are performing at a much lower level than they would’ve been in the past when rates were 7% or 8%? Is it holding true that the lower interest rate people are better payers of mortgages than the people from a decade ago or in the 2008 or 2009 market?

It certainly seems to be that trend. I draw a line somewhere in April of 2022 in forward production, and looking at those delinquency trends due to the higher PNI payment that they’re making due to a higher mortgage rate. You see a higher delinquency rate immediately on those loans, which speaks to that stress. Those folks that have equities could get a second, home equity line, stay in that low mortgage rate, and get a blended mortgage rate.

You’re going to see more closed-end seconds potentially produced instead of HELOCs for a blended rate for borrowers. It’s critical that servicers track the borrower information and try to understand if they are getting a second. Are they changing that LTV? There’s so much equity in a lot of that 2020 production and even the 2021 production. That waterfall of losses isn’t there. If you look at the FHA data, which is public, and you start looking at 60 FICO scores and below. You’ll see double-digit delinquencies. That’s a great employment situation. If we do lose 1% or 2% of that employment number, those FHA borrowers are going to become stressed quickly.

How do you think the regulatory environment around servicing and capital has changed materially in the last several years?

The scrutiny on MSR values is certainly going up. The advisory bulletin issued earlier in 2023 by the FHFA directed the enterprises, being Fannie and Freddie, to take a closer look at MSR valuations when managing counterparty risk. That’s something to be aware of. Having talked to the FHFA, they’re not trying to rewrite the MSR accounting rules, but they certainly want to acknowledge that if there’s a mismatch between people who have it marked on their books and where they could trade it, that has a direct impact on the equity. We’ll be interested to see how Fannie and Freddie roll that out.

We did get some alignment last August 2022 between the FHFA and Ginnie Mae around non-bank capital rules. Ginnie Mae has that risk-based capital element to it, which has been delayed until 2024, but that starts to feel a lot like Basel III for non-banks, at least from an equity position. A lot of scrutiny is going to be placed on the equity side to MSRs.

We’ve had bank failures. Bank failures were that they had a whole loan portfolio or an MBS portfolio that, until they had to monetize it, the loss was on paper. I hate to say it, but on the MSR side, we have some of that going on. We have a fair value and a trading value, which is lower. That’s analogous to what happens to those banks. There’s a run on banks. They had to sell those MBS and take the loss. If MBS has to do some of those losses, it could be harmful to their equity, which is what the advisory bulletin from the FHFA has pointed out.

When you look at the regulatory environment, and you’ve already talked about the capital changes and how it has an impact on the balance sheets of a lot of these companies, what are some of the other risk factors that people need to be taking into consideration? Is there anything out there that you’re saying, “This is not something people are looking at, but I’m concerned about?”

This goes off into the origination side. David, you may even want to comment on this, but if you’re doing it more of a distributed retail channel, you’ve got some receivables out there for expenses that you’ve incurred for those offices. If those offices go away or those receivables collectible, we’re all struggling. You’re shaking your head now.

Richey May has gone through its busy season with the audits. There are a lot of things to look at, including receivables. Loans help for investment, which are either repurchase loans. If you got stuck with some Ginnie Mae early buyouts, you bought out a 3% WAC, EBO loan, and rates went to 7%, and all of a sudden, that’s not trading well. There are some hidden potential losses there.

My biggest concern going forward is repurchase risk. Repurchase risk has been elevated. I’m concerned about the equity of IMDs to fight those repurchases. One thing when I was at SunTrust in 2008, and we hired 300 people to fight agency repurchases, we had such staff reduction in critical areas of independent mortgage companies because they had to cut expenses that some of them didn’t have the bandwidth to fight these repurchases.

Servicing Trends: Repurchase risk has been elevated. What is concerning is the equity of IMBs to actually fight those repurchases.

Is that an opportunity? We’re seeing several law firms step into that space and trying to go in. Is that an opportunity for some third parties that had to go in and help mitigate?

There’s a lot of work for folks who are experts on the origination quality side to help try to fight those repurchases for folks.

We have a sponsor on the show, Seth. It is Candor, who has automated underwriting on AI involved. One of the things they’ve created is that if they do the underwriting, they have an insurance policy to protect on repurchases if they missed anything. What do you feel about that concept in the industry? It seems to me it’s innovative and can be a big deal, but most repurchases are around the underwriting aspect, one aspect of it or another. How do you feel about that?

A lot of the repurchases are on the appraisal side or the underwriting side. I’m not sure if that policy covers the appraisal side or not. For some of this, I’m going to use the analogy of Jell-O to the wall. It’s like, “I’m not a fan of that loan. I’m going to push it back to you and see if I can get a repurchase.” There is some of that going on between the agencies and some of the aggregators. Some of these are valid. Others aren’t.

When you start layering in an insurance policy, it starts to get a little tricky as to the real reason for indemnification letters. We’ve certainly changed how repurchases are going. A true repurchase is a little less likely than indemnification. I don’t know if that insurance policy covers indems or not. That’s where they’re going to get out of having to pay.

That’s something that needs to be checked out. We need to ask them about indemnification. Your point is well taken between the underwriting and appraisal side. I doubt, seriously, it would underwrite the appraisal. The insurance policy would underwrite the appraisal. That’s so much still a third-party environment.

Candor also has the ability to go in on and help with the mitigation risk by going in and re-underwriting it after the fact. They’re able to provide some services to that. Shout out to Candor and their creativity for what they’re doing to bring innovation even into the servicing area and area repurchases. If you could wave a magic wand and change about servicing, what would that be?

My answer changes every day, Dave, based on what’s going on in the market. I know Mark has lived through this pain, given his background. This is a unicorn and lollipop concept. It is a national policy around foreclosure timelines and certainty of what the waterfall looks like across all investors. Even if we get it for the Ginnie Mae book, we level the playing field.

I’m a simple guy. I like to explain to people, “You’re running an origination business where you can’t control volumes that much. You certainly can’t control gain on sale.” There are some things you could do, but you don’t have control there. You layer in a potential servicing business, particularly in the Ginnie Mae space, where you have some of these long timelines and a lot of advances, and now you have unknowns on both sides.

If we could wave a magic wand and say, “Servicers are responsible for six months of advances maximum.” We’re going to do something. That would help create liquidity and certainty around what those losses could be. It would clean a lot of things up. That’s a broad comment to make because we have to deal with the FHA, VA, and USDA.

The more we could make a level playing field about this is what your losses are, they’re capped, and we’re going to do something else. That would help improve the liquidity, not only in the Ginnie May space but also make more people want to be in servicing because it’s a modelable amount of expenses. All we’re dealing with is the severity or frequency of it.

If I can live a magic wand, the nineteen basis point servicing strips should be outlawed. That’s not enough servicing cashflows. I realize that’s the best execution and its capital, but I’m not a fan of it, given where delinquencies are in that book. Sometimes, it is the nineteen basis point servicing strips. I know why it was put in. I understand it was bank-driven. It was capital light.

If you think about a $100,000 loan with a nineteen basis point servicing strip, it’s hard to see that loan being profitable. There are some issues around there. Fannie and Freddie have an efficient process of getting advances back. It’s a known amount you’d have to advance on an MBS. The more we can make it look like that on the Ginnie Mae side, that would help with the liquidity.

Your point was well taken about giving an example, the foreclosure timelines. Can you imagine how bad a war we’d be in if Federal bankruptcies were not a Federal law to regulate them? You have some states right now that can take 18 to 24 months to foreclose a piece of property. I’d even go so far as Seth to say, “Maybe we ought to put some restrictions on how long it takes to evict somebody out of a property.” In California, you can take eighteen months to get somebody evicted. There are a lot of things that affect this business. Who do they affect? They’re for all probit borrowers and all negative mortgage lenders. If you’re a small lender, that can have a dramatic effect. You’re 199% on target with your comments.

Protecting that servicing cashflow and understanding what that cash drain of servicing is. Anything we could do to fix that or make it a defined amount improves liquidity and ultimately lowers costs to borrowers. At the end of the day, all these servicing costs, advances we make, and foreclosure end up coming into gain on sale, and it gets passed onto the consumer.

Servicing Trends: Richey May does everything to ultimately lower costs to borrowers. They protect the servicing cash flow and get a better understanding of the cash drain.

I’m deeply concerned about the liquidity where we look at who’s holding the bulk of the MSRs out there, it’s banks, and we look at what happened as SVB and the market to market that could have a big impact on everything.

If you look at the origination numbers from Housing Policy Council, Ginnie Mae servicing is dominated by non-banks. Ginnie Mae servicing is the area where these advances are most likely to occur. That creates a liquidity problem. Those are the borrowers that need the most help getting into the mortgage. We know we’re going to have high LTV and not have 800 FICO scores in that book, but we place all the burden on the servicers. Those servicers have to get advanced lines from Goldman or from whoever’s left standing.

We’ve seen Credit Suisse. They’re not in the business anymore. You could read the same disclosures. I have of public companies, but people who had Credit Suisse are going somewhere else to get that financing. That financing isn’t cheap. It’s one thing when rates are zero, and you’re at zero plus 250 or 300 base points. We’re not at zero anymore. You’re talking 7% to 8% MSR financing and advanced lines. That doesn’t work. That’s the entire yield of the servicing.

What is the other side? What’s the ugly item of this whole scenario? Who is holding it?

The downside of this scenario is that there’s a significant reprice in that scenario of MSR values. It is going to cause mortgage rates to go up. Chopra made a comment. His biggest concern is a large servicer fails who services in-house. I hate to sound cavalier, but if it’s at a sub-servicer and what we’re dealing with is advancing payments or cash, that’s to me a much more solvable problem than when you have a servicer who’s servicing in-house goes out because all of a sudden you lose the staff. That’s where you get that borrower impact. Not that sub-servicers are great. They all get their fair share of complaints, but if it’s at a sub-servicer, I have a cash problem. If it’s in-house, I have a cash and an operational problem. That does keep me up at night that we could have a large failure like that.

Let’s talk a little bit about why you made the move over to Richey May. You’re running the consulting division. Tell us a little bit about what your focus is there and why people should want to pick up the phone and call you. There’s a lot of good reasons. Richey May is a well-established firm, but give us a little more insight into what you’re focusing on there.

Richey May offers a wide range of services. They’re known in the independent mortgage spaces for tax and audit work. We also do a lot of cybersecurity help, outsource, CTO, and penetration testing. I’m trying to help us develop our business intelligence platform. We’ve got a BI for more real-time analytics around that. We do a lot of work on servicing, retained, and released. It’s trying to help IMDs understand the risks they’re keeping or selling and what their cashflow risks are. We are trying to help them be profitable through that. We also do internal audits and outsourcing.

I’ve got sub-servicing oversight underneath me. For all the sub-servicer reviews, we go into set all at once for 40 customers because you go in and do one audit as opposed to 40. We do that for 8 or 9 of the top large sub-servicers. It is a good service for our customer base and sub-servicers. Most of my time is spent, if I’m not doing policy work, is spent trying to help companies understand the risk retained, their capital market structure, their servicing structure, and understanding whether this asset makes sense for them. Do these cashflows fit with your strategy? Define your strategy, and let’s retain servicing that makes sense for your strategy or not retain servicing if that fits your strategy.

I know there are going to be a lot of questions. We’re going to want to have you back and to talk about this. What is the best way for people to connect with you?

The best way is to reach out to my email address. It’s [email protected]. You can also find me on LinkedIn, where it’s got both my cell phone contact information and my Richey May email address. I do post on LinkedIn fairly regularly mortgage stuff. People can find me either through the Richey May website, www.RicheyMay.com, [email protected], or even on my LinkedIn account.

Seth, thank you so much for coming on and joining Mark and me and being on the show. I appreciate it

It’s always a pleasure to talk to you, David and Mark. It’s nice to meet you, David. Anything I could do to try to help this industry get a little bit better is what I’m here to do.

Thank you so much. I appreciate it, Seth.

Thank you all.

Important Links

• Richey May
• Candor
• [email protected]
• LinkedIn – Seth Sprague