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Why mortgage servicing rights can hedge interest rate risk

Brent Nyitray, CFA

Mortgage REIT 101: What is a mortgage servicing right? (Part 2 of 5)

(Continued from Part 1)

Mortgage servicing rights are residual assets from mortgage origination

Mortgage servicing rights (MSRs) are residual assets that mortgage originators usually retain after selling a mortgage into a mortgage-backed security. While a few companies specialize in servicing—particularly Ocwen (OCN) and Nationstar (NSM)—MSRs are usually held on the balance sheets of banks. MSRs are interesting assets that can hedge interest rate risk. That said, they can also imply some scary consequences for mortgage servicers.

A mortgage servicing right is the present value of the expected payments from servicing a mortgage

Your mortgage servicer is the company that sends your monthly mortgage bill, processes your payment, maintains your escrow balances, and remits principal and interest payments to the ultimate holders of your mortgage. The servicer is compensated for this service with an interest rate spread. Say you’re paying 3.5% on your FHA (Federal Housing Administration) mortgage. Your 3.5% mortgage would pool into a 3% coupon Ginnie Mae mortgage-backed security.

The servicer would collect your 3.5% payment and remit the 3% payment to the bondholder, who is probably a mortgage REIT investor like American Capital (AGNC) or Annaly (NLY). The payment to the bondholders is less than the payment you make on your mortgage. The payment difference is the compensation to the servicer (and the government). The government collects a 6 basis point “guarantee fee” (which is its compensation for guaranteeing the payment of principal and interest for the borrower), and the remainder of the fees is the servicer’s payment.

In addition, the servicer gets the float on your money. Your mortgage payment may be due on the 1st of the month, while the underlying bond pays out towards the end of the month. During that time, your payment sits in an account, collecting interest. The servicer gets to keep that interest.

Continue to Part 3

  • Part 1 - Mortgage servicing rights increase in value as interest rates rise
  • Part 3 - Why mortgage servicing rights imply risks for servicers
  • Part 4 - Must-know: Mortgage servicing rights and interest rates