OASIS: A Securitization Born from MSR Transfers

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1 URBAN INSTITUTE HOUSING FINANCE POLICY CENTER COMMENTARY OASIS: A Securitization Born from MSR Transfers BY LAURIE GOODMAN AND PAMELA LEE On February 25, Ocwen Loan Servicing, the nation s largest nonbank mortgage servicer, 1 completed a new type of quasi-securitization, Ocwen Asset Servicing Income Series (OASIS ). Other nonbank servicers reportedly are working on similar transactions. OASIS was developed to help Ocwen fund its servicing business, which has been growing as mortgage servicing has shifted from depository institutions to nonbanks. This shift has occurred in response to Basel III regulations, which make it more costly than in the past for large banks to hold mortgage servicing rights (MSRs). 2 In this commentary, we describe the changing mortgage servicing market and the reasons for those changes. We then look at Ocwen s new security, its purpose, and its appeal to investors. Mortgage Servicing Rights Have Shifted from Banks to Nonbanks Mortgage servicing has typically been dominated by the big banks that also originate and securitize most US residential loans. According to Inside Mortgage Finance, for the past six years, the top three mortgage servicers by market share have remained unchanged Wells Fargo, Chase, and (not always in that order). What has changed is the rapid spike in the share of the servicing market now held by nondepository institutions that specialize in servicing mortgage loans. Table 1 shows the Top 10 mortgage servicers in 2013 (nonbank institutions are shaded in blue). With one exception, the largest banks reduced their balance of MSRs between the fourth quarters of 2012 and reduced its MSR footprint by nearly 40 percent, and more than halved its overall share between 2011 and 2013; meanwhile, Chase reduced its mortgage servicing share by 9 percent since In contrast, the country s largest nonbank servicers (in order, Ocwen, Nationstar, PHH, Walter, and Quicken) saw their market share grow, by as much Table 1: Top 10 Mortgage Servicers in 2013 Overall Market Rank Servicer Nonbank Ranking 2013 Share of Total Mortgage Servicing Market Change in Market Share 4Q12 4Q13 Change in Market Share Wells Fargo NA 18.5% 2% 4% 2 Chase NA 10.3% 8% 9% 3 NA 8.2% 39% 52% 4 Ocwen Financial Corp 1 4.6% 124% 376% 5 Nationstar Mortgage 2 4.2% 100% 320% 6 Citi NA 4.0% 13% 23% 7 US Bank Home Mortgage NA 2.7% 2% 17% 8 PHH Mortgage 3 2.3% 23% 28% 9 Walter Investment Management 4 2.0% 130% NA 10 Quicken Loans 5 1.4% 75% NA Source: Inside Mortgage Finance 1

2 as 130 percent, between the fourth quarter of 2012 and the fourth quarter of (Ocwen, Nationstar, and Walter are primarily servicers, though they do some lending; Quicken and PHH are nonbank originators and servicers.) As of 2013, five of the top 10 mortgage servicing firms were nonbanks (accounting for 15 percent of the total mortgage servicing market); in contrast, nine of the top 10 servicers were banks in 2011, and in 2012, just two were nonbanks (representing 4 percent of the total market). The one nonbank that has made appearances in the top 10 since 2008 (table 2) has never accounted for more than 2 percent of the total market. Table 3 looks at the share of the overall servicing market held by the top 10 servicers. The shift in market share between banks and nonbanks in 2013 is striking. And a good deal of this represents the transfer of servicing of distressed loans. Many of the major banks that have sold servicing rights have disproportionately sold distressed servicing, which requires a very high touch. Major banks have not developed the infrastructure to support a large amount of high touch activity. In addition, banks may view distressed servicing as a continuing reputational drain, at a point when they are actively trying to repair reputational damage from the crisis. The major sellers of nondistressed servicing have been Ally and Flagstar, both of which have experienced financial difficulties. The rapid growth of nonbank servicers has not gone unnoticed. Representative Maxine Waters (D-CA) recently urged federal regulators to hold nonbank servicers to heightened scrutiny. New York s top banking regulator is evaluating several pending major MSR transactions in which Ocwen and Nationstar are the acquirers. What s Behind the Growth of Nonbank Servicers? The largest banks have been stepping back from the $10 trillion MSR market in anticipation of implementation of the Basel III bank capital standards, primarily through sales of distressed servicing we would expect sales of nondistressed servicing to follow. Basel III boosts the amount and quality of capital that banks must hold. 3 Adopted by US regulators in 2013, it is a postcrisis update to the international Basel Accords, a comprehensive set of banking reforms to strengthen the safety and soundness of financial markets. Basel I established a risk-based capital framework under which different asset classes are assigned risk weights that correspond to their potential to default. The amount of capital a bank must hold against an asset class is based on multiplying the bank s holdings of that class by the risk weight. Although some major risk classes, including most residential mortgages, are unchanged under Basel III, the new regime makes major changes to Table 2: Top 10 Mortgage Servicers by Market Share, Rank % 20% 2 Wells Fargo 16% Wells Fargo 17% Wells Fargo 17% 20% Wells Fargo 18% Wells Fargo 19% Wells Fargo 19% 17% 13% Chase 10% 3 Chase 14% Chase 13% Chase 12% Chase 11% Chase 11% 8% 4 CitiMortgage 7% Citi 7% Citi 6% Citi 5% Citi 4% Ocwen 5% 5 Residential Capital 3% GMAC 3% Ally 3% Ally 4% US Bank 3% Nationstar 4% 6 National City 2% SunTrust 2% US Bank 2% US Bank 2% Nationstar 2% Citi 4% 7 IndyMac 2% US Bank 2% PHH Mortgage 2% PHH Mortgage 2% PHH Mortgage 2% US Bank 3% 8 SunTrust 1% OneWest 2% SunTrust 2% SunTrust 2% Residential 2% PHH Mortgage 2% Bank Capital 9 PHH Mortgage 1% PNC Mortgage 1% OneWest 1% PNC Mortgage 1% SunTrust 1% Walter 2% 10 HSBC North 1% PHH Mortgage 1% PNC Mortgage 1% OneWest 1% PNC Mortgage 1% Quicken Loans 1% Source: Inside Mortgage Finance 2

3 Table 3: Share of Servicing Market Held by Top 10 Servicers Top 10 Servicers Bank Share 65% 66% 64% 61% 54% 44% Nonbank Share 1% 1% 2% 2% 4% 15% Source: Inside Mortgage Finance and Urban Institute the treatment of MSRs. MSR treatment under pre- Basel III standards and under Basel III is summarized in table 4. Basel III rules will likely increase the cost of holding MSR assets. MSRs are an asset on a bank s balance sheet. Previously, as long as banks held MSRs as less than 50 percent of their core Tier 1 capital (the key measure of a bank s financial strength), a base MSR risk weight of 100 percent applied. Capital was required to be held dollar for dollar over the very high limit. Basel III shrinks the amount of MSRs that will be subject to the lower risk weight, and raises the minimum MSR risk weight. Under Basel III, MSRs up to 10 percent of Tier 1 capital (with a more stringent definition of Tier 1 capital) will receive a 250 percent risk weight. Capital must be held dollar for dollar over this more modest limit. There are situations in which punitive capital charges will apply even if MSRs are less than 10 percent. Under Basel III, if the combined balance of MSRs, deferred tax assets, and significant investments in shares of unconsolidated financial institutions 4 exceeds 15 percent, MSRs over that limit will be subject to the dollar-for-dollar capital charge. For example, if an institution has 9 percent MSRs and 9 percent deferred tax assets and significant investments in shares of unconsolidated financial institutions, 6 percent of the MSRs will be subject to a 250 percent risk weight, and the balance will be subject to a dollar-for-dollar capital charge. Let s take the example of two hypothetical banks: one with MSR holdings that are within Basel III s threshold requirements, and another with MSR assets that exceed the thresholds. (Analysts 5 indicate that current MSR holdings at most large and mid-size banks are within the 10 percent Tier 1 requirement. For most banks, the binding constraint will be the combined 15 percent threshold.) MSR assets currently carry a minimum capital requirement of 17.2 percent (10 percent haircut 6 plus 8 percent capital standard times 100 percent risk weight). Assuming an 8 percent Tier 1 capital standard and removal of the 10 percent haircut, a bank that is under the 10 percent individual and 15 percent combined thresholds will see the minimum capital requirement for MSRs increase to 20 percent (8 percent capital requirement times 250 percent risk weight). This does not seem to be a significant increase over current regulatory capital treatment of MSRs. However, for banks holding MSRs above the thresholds, the capital requirement will grow from the 17.2 percent Basel I requirement to 100 percent for MSRs exceeding the 10 percent MSR limit, or the 15 percent combined limit under Basel III. Table 4: Treatment of MSRs Pre-Basel III Standards Capital Exclusion MSRs are limited to 50 percent of Tier 1 capital for banks, 100 percent for savings and loans. No limitation on combined balance of MSRs, deferred tax assets, and significant investments in shares of unconsolidated financial institutions. 10 percent haircut on face value Risk Weight Included MSRs have a 100 percent risk weight Excluded MSR balance (10 percent) haircut subject to dollar-for-dollar capital requirement Basel III 10 percent cap on MSR contribution to capital. Combined balance of MSRs, deferred tax assets, and significant investments in shares of unconsolidated financial institutions is subject to a 15 percent cap. Regulators have decided to remove the haircut Included MSRs have a 250 percent risk weight Excluded MSR balance subject to dollar-for-dollar capital requirement Source: Credit Suisse and Urban Institute 3

4 To some extent, regulations designed to strengthen the financial system by increasing bank capital and liquidity requirements may be making it less attractive for banks to service the mortgages they hold, driving a wedge between the servicing and origination of loans. Correspondingly, the actions of the large banks in anticipation of Basel III have created an opportunity for nonbanks to step into the servicing market. For example, late last year, Citigroup sold MSRs on 21 percent of its total contracts, $63 billion of loans. According to Inside Mortgage Finance, about $1.03 trillion of MSRs were sold in 2013, with the vast majority going to nonbank firms. As banks continue reducing their MSR holdings, nonbanking servicers have plans to expand their MSR purchases and lending business. The amount of outstanding mortgages serviced by Ocwen, the nation s largest nonbank servicer, has increased more than 10 times, from $43 billion in 2005 to more than $500 billion in the fourth quarter of The Purpose of OASIS To help finance future purchasing of MSR assets and diversification of its business, on February 25, 2014, Ocwen sold $123.5 million of a new type of MSR-backed bond, Ocwen Asset Servicing Income Series Ocwen has said that it may sell as much as $1 billion of the bonds this year. OASIS is secured by the company s MSRs relating to $11.8 billion in an unpaid principal balance of Freddie Mac 30-year fixed-rate mortgages. Ocwen s OASIS was designed to provide matched financing for future MSRs, and to help hedge against prepayment risk linked to MSRs. This first deal was backed by GSE loans; we believe that choice was motivated by two considerations: (1) investors are very familiar with evaluating agency prepayment risk and (2) GSE loans are far more prepayment sensitive than many of the more distressed loans that Ocwen services. This is reminiscent of the GSEs recent risk-sharing transactions (Freddie s STACR series and Fannie s CAS series), in that the deal is synthetic but the risk is transferred: In this case the MSR assets continue to reside on Ocwen s balance sheet, Ocwen continues to service the loans, but the prepayment risk is transferred to private investors. (In the GSE risksharing deals, it is credit risk that is transferred.) These MSRs could have been funded with long-term secured debt. However, in a typical secured debt offering, there would have been a basic mismatch between debt financing and the value of the MSRs 7 : If interest rates fall, then mortgages are likely to prepay faster, which would reduce the value of the MSRs, meaning that Ocwen would have raised an excess amount of financing relative to the value of the MSR assets it financed with the debt; if rates rise, then prepayments slow, increasing the value of the MSRs, resulting in Ocwen s debt financing covering less of the value of the MSRs. Thus, traditional debt would have provided fixed financing for Ocwen s MSR portfolio, and would not match the variable value of an MSR portfolio over time. Hedging may also have been a motivation. A traditional bank portfolio includes both origination activity and a portfolio of MSRs. For bank originators, MSRs are a natural hedge for their origination business. That is, as interest rates rise, origination volumes fall, and origination margins compress, but MSRs become more valuable as prepayments slow. The reverse is true as interest rates fall. Thus, combining mortgage origination with MSRs tends to produce a more stable earnings stream than either activity alone. Most of the nonbank servicers that are scooping up MSRs (Ocwen, Nationstar, and Walter, to name a few) lack large origination platforms; thus, there is no natural hedging. As a result, laying off some of this interest rate risk makes sense. As the offloading of MSRs from banks to nonbank servicers continues (and it will, due to Basel III), we can expect to see more transactions that serve to hedge nonbank MSR portfolios. The Structure of OASIS This deal is a private placement, offered to select investors. The 17 accounts that invested in the bonds were dominated by hedge funds that had previously invested in Ocwen debt. OASIS is a direct obligation of Ocwen (a debt offering), and (like the GSE risk-sharing transactions) technically not a securitization. The MSRs on the $11.8 billion of 4

5 Freddie Mac mortgages are pledged as collateral for the debt offering and also serve as the reference pool. The 14-year debt obligation offers investors an interest-only strip that pays a monthly share of 21 basis points (bps), representing the servicing value on the mortgages. Put another way, OASIS will pay a monthly amount calculated as 0.21 percent of interest on the principal balance of the loans over 14 years. OASIS was sold for roughly five times that amount, or $1.05, which is what Ocwen and investors view as the present value of the loans future servicing income. At the end of the 14-year period (the stated maturity), Ocwen will pay investors a redemption payment valued at the unpaid principal balance of the loans times the initial purchase price (1.05 percent). As the mortgages pay down, because of prepayments or regularly scheduled amortization, the MSR and the cash flow payable on the bonds will decrease proportionately. It s easy to see the appeal of OASIS notes to investors: The notes are among the few fixedincome instruments that perform well in a rising interest rate environment. Rising rates lower the value of a fixed-income portfolio; rising rates also will slow prepayments, increasing the period of time that the cash flow will continue and hence raising the value of this debt. In addition to general interest rate risk, investors face a risk that Ocwen may be overzealous about refinancing its own mortgages. If Ocwen refinances the mortgages in the OASIS pool, then it will be able to place new, more valuable MSRs in its portfolio, to the detriment of OASIS s investors. To partially mitigate this risk, there are limitations on the cumulative amount of Ocwen refinances to total refinances: If Ocwen s refinances exceed this total Ocwen must buy out these excess paydowns, essentially making investors whole on the excess. Conclusion Ocwen s new transaction makes a lot of sense for both Ocwen and the investors. More broadly, the huge move of mortgage servicing from banks to nonbanks reflects the unintended consequences of regulatory reforms designed to strengthen the financial system. Banks have sold distressed MSRs both because they do not service these assets as efficiently as some of the nonbank servicers, and to escape costly capital requirements under Basel III. Over time, we would expect to see more transfers of nondistressed MSRs and more transactions like the OASIS deal. Endnotes 1 A mortgage lender is the institution that provides borrowers with money; the servicer handles the daily tasks of managing the loan, processing loan payments, responding to borrower inquiries, tracking interest and principal paid, and initiating foreclosure if a borrower misses too many loan payments. The servicer may or may not be the same company that originated the loan. 2 This refers to a contractual agreement where the rights to service an existing mortgage are sold by the original lender to another party that specializes in the various functions of servicing mortgages. 3 Federal regulators are adapting Basel III for gradual phase-in, beginning in 2014 and to be completed by Considered a significant investment if a bank holds more than 10 percent of another financial institution s common shares; insignificant if less than 10 percent of another financial institution s common shares. 5 See Sarah Hu and Jeana Curro (June 26). MSR Hedging in the Current Market Environment. Royal Scotland: MBS Strategy Report, Special Report. 6 Under section 475 (b) of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, MSR assets receive a 10 percent haircut on fair market value. This haircut has been eliminated in Basel III. 7 Ocwen accounts for their MSRs on a lower of cost or market (LOCOM) basis. Most of the larger servicers account for MSRs on a mark-to-market basis. This accounting difference does not change the arguments above. 5

6 Copyright March The Urban Institute. All rights reserved. Permission is granted for reproduction of this file, with attribution to the Urban Institute. The Urban Institute is a nonprofit, nonpartisan policy research and educational organization that examines the social, economic, and governance problems facing the nation. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. The Housing Finance Policy Center s (HFPC) mission is to produce analyses and ideas that promote sound public policy, efficient markets, and access to economic opportunity in the area of housing finance. We would like to thank The Citi Foundation and The John D. and Catherine T. MacArthur Foundation for providing generous support at the leadership level to launch the Housing Finance Policy Center. Additional support was provided by the Ford Foundation and the Open Society Foundations. 6