BY HAFIZAN HAMZAH
Does your credit union service mortgage loans? If so, you’re probably familiar with the price volatility involved with mortgage servicing rights assets. But such temperamental tendencies need not deter your CU from heavily involving itself in mortgage banking. These two approaches will help you hedge your MSR bets.
A byproduct of focusing on single-family mortgage originations is often creating mortgage servicing rights (MSR) assets as the mortgages are sold to other parties. An MSR asset is the right to service mortgage loans, even if they are not held on the balance sheet, in exchange for a fee agreed upon at sale. For institutions with competitive advantages in servicing mortgages, MSR assets can offer significant returns on capital.
Even with small changes in interest rates, MSRs can show a significant amount of price volatility, depending on the current level of rates. For example, if rates are a lot higher than the mortgage’s coupon, small changes away from that level have little impact on the asset. That is because they are often among the most volatile assets on the balance sheet. The Basel Committee clearly recognizes this risk with its Basel III final ruling, which assigns MSR assets a 250 percent risk weighting. The inherent price volatility of MSR assets makes hedging considerations very important for institutions that are heavily involved in mortgage banking.
Why are MSR assets so volatile?
To understand this volatility, MSRs can be compared to interest-only (IO) strips on mortgage bonds, which entitle their owners to receive the interest portion of the underlying bond’s payments. Like IOs, MSR assets entitle the institution to a stream of servicing fees over the life of the underlying mortgages, and the longer the life, the better. Falling interest rates (and increasing prepayment speeds) are very punitive to an IO’s price due to the income stream’s shortening with no offsetting principal effect. Like most mortgage bonds, MSRs also tend to exhibit negative convexity. This means as interest rates decline, the value of the asset also declines at an increasing rate.