HOUSING FINANCE POLICY CENTER COMMENTARY

URBAN

INSTITUTE

OASIS: A Born from MSR Transfers BY LAURIE GOODMAN AND PAMELA LEE

On February 25, Ocwen Loan Servicing, the nation’s US residential loans. According to Inside Mortgage largest nonbank mortgage servicer,1 completed a Finance, for the past six years, the top three new type of quasi-securitization, Ocwen Asset mortgage servicers by market share have remained Servicing Income Series (OASIS 2014-1). Other unchanged—, Chase, and of nonbank servicers reportedly are working on America (not always in that order). What has similar transactions. OASIS 2014-1 was developed changed is the rapid spike in the share of the to help Ocwen fund its servicing , which servicing market now held by nondepository has been growing as mortgage servicing has shifted institutions that specialize in servicing mortgage from depository institutions to nonbanks. This shift loans. has occurred in response to Basel III regulations, which make it more costly than in the past for large Table 1 shows the Top 10 mortgage servicers in to hold mortgage servicing rights (MSRs).2 In 2013 (nonbank institutions are shaded in blue). this commentary, we describe the changing With one exception, the largest banks reduced their mortgage servicing market and the reasons for balance of MSRs between the fourth quarters of those changes. We then look at Ocwen’s new 2012 and 2013. reduced its MSR , its purpose, and its appeal to investors. footprint by nearly 40 percent, and more than halved its overall share between 2011 and 2013; Mortgage Servicing Rights Have meanwhile, Chase reduced its mortgage servicing share by 9 percent since 2011. Shifted from Banks to Nonbanks In contrast, the country’s largest nonbank servicers Mortgage servicing has typically been dominated by (in order, Ocwen, Nationstar, PHH, Walter, and the big banks that also originate and securitize most Quicken) saw their market share grow, by as much

Table 1: Top 10 Mortgage Servicers in 2013 Overall 2013 Share of Change in Change in Market Nonbank Total Mortgage Market Share Market Share Rank Servicer Ranking Servicing Market 4Q12–4Q13 2011–2013 1 Wells Fargo NA 18.5% –2% 4% 2 Chase NA 10.3% –8% –9% 3 Bank of America 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 4 2.0% 130% NA 10 Quicken Loans 5 1.4% 75% NA Source: Inside Mortgage Finance

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

Table 2: Top 10 Mortgage Servicers by Market Share, 2008–2013 Rank 2008 2009 2010 2011 2012 2013 Bank of Bank of Bank of 1 19% 20% 20% Wells Fargo 18% Wells Fargo 19% Wells Fargo 19% America America America Bank of Bank of 2 Wells Fargo 16% Wells Fargo 17% Wells Fargo 17% 17% 13% Chase 10% America America Bank of 3 Chase 14% Chase 13% Chase 12% Chase 11% Chase 11% 8% America 4 CitiMortgage 7% Citi 7% Citi 6% Citi 5% Citi 4% Ocwen 5% Residential 5 3% GMAC 3% Ally 3% Ally 4% US Bank 3% Nationstar 4% Capital 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% OneWest Residential 8 SunTrust 1% 2% SunTrust 2% SunTrust 2% 2% PHH Mortgage 2% Bank Capital 9 PHH Mortgage 1% PNC Mortgage 1% OneWest 1% PNC Mortgage 1% SunTrust 1% Walter 2% HSBC North 10 1% PHH Mortgage 1% PNC Mortgage 1% OneWest 1% PNC Mortgage 1% Quicken Loans 1% America Source: Inside Mortgage Finance

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Table 3: Share of Servicing Market Held by Top 10 Servicers Top 10 Servicers 2008 2009 2010 2011 2012 2013 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- subject to a 250 percent risk weight, and the balance Basel III standards and under Basel III is will be subject to a dollar-for-dollar capital charge. summarized in table 4. Basel III rules will likely increase the cost of holding MSR assets. Let’s take the example of two hypothetical banks: one with MSR holdings that are within Basel III’s MSRs are an asset on a bank’s balance sheet. threshold requirements, and another with MSR assets Previously, as long as banks held MSRs as less than that exceed the thresholds. (Analysts5 indicate that 50 percent of their core Tier 1 capital (the key current MSR holdings at most large and mid-size measure of a bank’s financial strength), a base MSR banks are within the 10 percent Tier 1 requirement. risk weight of 100 percent applied. Capital was For most banks, the binding constraint will be the required to be held dollar for dollar over the very combined 15 percent threshold.) MSR assets currently high limit. Basel III shrinks the amount of MSRs carry a minimum capital requirement of 17.2 percent that will be subject to the lower risk weight, and (10 percent haircut6 plus 8 percent capital standard raises the minimum MSR risk weight. Under times 100 percent risk weight). Assuming an 8 percent Basel III, MSRs up to 10 percent of Tier 1 capital Tier 1 capital standard and removal of the 10 percent (with a more stringent definition of Tier 1 capital) haircut, a bank that is under the 10 percent individual will receive a 250 percent risk weight. Capital must and 15 percent combined thresholds will see the be held dollar for dollar over this more modest limit. minimum capital requirement for MSRs increase to There are situations in which punitive capital 20 percent (8 percent capital requirement times charges will apply even if MSRs are less than 250 percent risk weight). This does not seem to be a 10 percent. Under Basel III, if the combined balance significant increase over current regulatory capital of MSRs, deferred assets, and significant treatment of MSRs. investments in shares of unconsolidated financial institutions4 exceeds 15 percent, MSRs over that However, for banks holding MSRs above the limit will be subject to the dollar-for-dollar capital thresholds, the capital requirement will grow from charge. For example, if an institution has 9 percent the 17.2 percent Basel I requirement to 100 percent MSRs and 9 percent deferred tax assets and for MSRs exceeding the 10 percent MSR limit, or significant investments in shares of unconsolidated the 15 percent combined limit under Basel III. financial institutions, 6 percent of the MSRs will be

Table 4: Treatment of MSRs Pre-Basel III Standards Basel III Capital Exclusion • MSRs are limited to 50 percent of Tier 1 capital for banks, • 10 percent cap on MSR contribution to capital. Combined 100 percent for savings and loans. No limitation on balance of MSRs, deferred tax assets, and significant combined balance of MSRs, deferred tax assets, and investments in shares of unconsolidated financial significant investments in shares of unconsolidated financial institutions is subject to a 15 percent cap. institutions. • Regulators have decided to remove the haircut • 10 percent haircut on face value Risk Weight • Included MSRs have a 100 percent risk weight • Included MSRs have a 250 percent risk weight • Excluded MSR balance (10 percent) haircut subject to • Excluded MSR balance subject to dollar-for-dollar capital dollar-for-dollar capital requirement requirement Source: Credit Suisse and Urban Institute

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To some extent, regulations designed to strengthen transferred to private investors. (In the GSE risk- the financial system by increasing bank capital and sharing deals, it is that is transferred.) liquidity requirements may be making it less attractive for banks to service the mortgages they These MSRs could have been funded with long-term hold, driving a wedge between the servicing and secured . However, in a typical secured debt origination of loans. Correspondingly, the actions of offering, there would have been a basic mismatch the large banks in anticipation of Basel III have between debt financing and the value of the MSRs7: If created an opportunity for nonbanks to step into rates fall, then mortgages are likely to prepay the servicing market. For example, late last year, faster, which would reduce the value of the MSRs, sold MSRs on 21 percent of its total meaning that Ocwen would have raised an excess contracts, $63 billion of loans. According to Inside amount of financing relative to the value of the MSR Mortgage Finance, about $1.03 trillion of MSRs assets it financed with the debt; if rates rise, then were sold in 2013, with the vast majority going to prepayments slow, increasing the value of the MSRs, nonbank firms. resulting in Ocwen’s debt financing covering less of the value of the MSRs. Thus, traditional debt would As banks continue reducing their MSR holdings, have provided “fixed” financing for Ocwen’s MSR nonbanking servicers have plans to expand their portfolio, and would not match the variable value of MSR purchases and lending business. The amount of an MSR portfolio over time. outstanding mortgages serviced by Ocwen, the nation’s largest nonbank servicer, has increased Hedging may also have been a motivation. A more than 10 times, from $43 billion in 2005 to traditional bank portfolio includes both origination more than $500 billion in the fourth quarter of 2013. activity and a portfolio of MSRs. For bank originators, MSRs are a natural for their The Purpose of OASIS 2014-1 origination business. That is, as interest rates rise, origination volumes fall, and origination margins To help finance future purchasing of MSR assets compress, but MSRs become more valuable as and diversification of its business, on February 25, prepayments slow. The reverse is true as interest 2014, Ocwen sold $123.5 million of a new type of rates fall. Thus, combining mortgage origination MSR-backed bond, Ocwen Asset Servicing Income with MSRs tends to produce a more stable earnings Series 2014-1. Ocwen has said that it may sell as stream than either activity alone. much as $1 billion of the bonds this year. OASIS 2014-1 is secured by the company’s MSRs relating Most of the nonbank servicers that are scooping up to $11.8 billion in an unpaid principal balance of MSRs (Ocwen, Nationstar, and Walter, to name a 30-year fixed-rate mortgages. few) lack large origination platforms; thus, there is no natural hedging. As a result, laying off some of Ocwen’s OASIS 2014-1 was designed to provide this makes sense. As the offloading “matched” financing for future MSRs, and to help of MSRs from banks to nonbank servicers continues hedge against prepayment risk linked to MSRs. This (and it will, due to Basel III), we can expect to see first deal was backed by GSE loans; we believe that more transactions that serve to hedge nonbank choice was motivated by two considerations: MSR portfolios. (1) investors are very familiar with evaluating agency prepayment risk and (2) GSE loans are far more The Structure of OASIS 2014-1 prepayment sensitive than many of the more distressed loans that Ocwen services. This is This deal is a private placement, offered to select reminiscent of the GSEs’ recent risk-sharing investors. The 17 accounts that invested in the bonds transactions (Freddie’s STACR series and Fannie’s were dominated by hedge funds that had previously CAS series), in that the deal is synthetic but the risk invested in Ocwen debt. OASIS 2014-1 is a direct is transferred: In this case the MSR assets continue obligation of Ocwen (a debt offering), and (like the to reside on Ocwen’s balance sheet, Ocwen continues GSE risk-sharing transactions) technically not a to service the loans, but the prepayment risk is securitization. The MSRs on the $11.8 billion of

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Freddie Mac mortgages are pledged as collateral for Banks have sold distressed MSRs both because they the debt offering and also serve as the reference pool. do not service these assets as efficiently as some of the nonbank servicers, and to escape costly capital The 14-year debt obligation offers investors an requirements under Basel III. Over time, we would interest-only strip that pays a monthly share of expect to see more transfers of nondistressed MSRs 21 basis points (bps), representing the servicing and more transactions like the OASIS deal. value on the mortgages. Put another way, OASIS will pay a monthly amount calculated as Endnotes 0.21 percent of interest on the principal balance of the loans over 14 years. OASIS was sold for roughly 1 A mortgage lender is the institution that provides five times that amount, or $1.05, which is what borrowers with money; the servicer handles the Ocwen and investors view as the present value of daily tasks of managing the loan, processing loan the loans’ future servicing income. At the end of the payments, responding to borrower inquiries, 14-year period (the stated maturity), Ocwen will tracking interest and principal paid, and initiating pay investors a redemption payment valued at the if a borrower misses too many loan unpaid principal balance of the loans times the payments. The servicer may or may not be the same initial purchase price (1.05 percent). As the company that originated the loan. mortgages pay down, because of prepayments or 2 regularly scheduled amortization, the MSR and the This refers to a contractual agreement where the cash flow payable on the bonds will decrease rights to service an existing mortgage are sold by proportionately. the original lender to another party that specializes in the various functions of servicing mortgages. It’s easy to see the appeal of OASIS notes to 3 investors: The notes are among the few fixed- Federal regulators are adapting Basel III for income instruments that perform well in a rising gradual phase-in, beginning in 2014 and to be interest rate environment. Rising rates lower the completed by 2018. value of a fixed-income portfolio; rising rates also 4 Considered a significant investment if a bank will slow prepayments, increasing the period of time holds more than 10 percent of another financial that the cash flow will continue and hence raising institution’s common shares; insignificant if less the value of this debt. than 10 percent of another financial institution’s In addition to general interest rate risk, investors common shares. face a risk that Ocwen may be overzealous about 5 See Sarah Hu and Jeana Curro. 2012 (June 26). refinancing its own mortgages. If Ocwen refinances MSR Hedging in the Current Market Environment. the mortgages in the OASIS pool, then it will be able Royal Bank of Scotland: MBS Strategy Report, to place new, more valuable MSRs in its portfolio, to Special Report. the detriment of OASIS’s investors. To partially mitigate this risk, there are limitations on the 6 Under section 475 (b) of the Federal Deposit cumulative amount of Ocwen refinances to total Corporation Improvement Act (FDICIA) refinances: If Ocwen’s refinances exceed this total of 1991, MSR assets receive a 10 percent haircut on Ocwen must “buy out” these excess paydowns, fair market value. This haircut has been eliminated essentially making investors whole on the excess. in Basel III.

Conclusion 7 Ocwen accounts for their MSRs on a lower of cost or market (LOCOM) basis. Most of the larger Ocwen’s new transaction makes a lot of sense for both servicers account for MSRs on a mark-to-market Ocwen and the investors. More broadly, the huge basis. This accounting difference does not change move of mortgage servicing from banks to nonbanks the arguments above. reflects the unintended consequences of regulatory reforms designed to strengthen the financial system.

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Copyright © March 2014. 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.

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