REQUIRED READING: There is a void developing in the competitive landscape of correspondent lending. Many former leaders in the sector either have left or are curtailing their activity. Soon, there will be few real options for correspondent sellers to achieve the economic value of the servicing rights they are producing.
There have been several new entrants into the correspondent space, and more are reportedly on the way – but they are operating on a flawed business model: They think that they can garner sizable market share by having fewer overlays because of no legacy issues with the agencies. So far, their pricing is not competitive, and consequently, they will be adversely selected and will only buy loans that don't ‘fit’ the overlays of the more aggressive companies.
With correspondents paying never-before-seen low multiples for the servicing rights, there is certainly room in the pricing matrix to justify paying higher multiples to compete and to buy more than ‘one-off’ loans. The most aggressive pricers are still only paying approximately four times the service fee, while the others are pricing at two to three times the service fee.
It is no secret that the loans being produced today are of the highest quality in the last 25 years. But the economic value of the loans being produced today is well in excess of the prices being paid by the correspondent lending ‘cartel,’ and it may well be double what is being paid.
Because of correspondent overlays and the weak multiples being paid for servicing, increasing numbers of originators are gaining their agency approvals and retaining the servicing rights. This was the norm 15 to 20 years ago, when few originators sold their servicing, except through occasional bulk sales or forward flow agreements. Back in the day, most correspondents retained the loans and serviced them.
The price is right?
Today, the smart companies and those with access to capital are pursuing this strategy or are preparing to do so, as a way to realize the economic value of their loan production. With relatively few ‘real’ correspondent buyers, the concentration has never been greater.
The leading correspondent lender is achieving approximately a 30% market share. These are oligopolistic levels. But who will fill the void and correct the imbalance?
If any of the new entrants were to price comparably to this market leader, they would gain immediate volume increases, as most correspondent sellers are uncomfortable having only one buyer at a three to four multiple of the service fee. This market leader is also taking upwards of three weeks to review loans for purchase, which puts strains on many participants' warehouse lines.
Most of the ‘old guard’ correspondent lenders have an elaborate pricing methodology to give the appearance of precision and a degree of esoterica. The truth of the matter is that it is a way of disguising the fact that they are paying very little for the servicing rights. At least the new entrants have an easy and transparent pricing structure, base price (the securities price with a haircut), plus a suggested retail price (albeit a weak one).Â
At the end of the day, you can complicate the pricing as much as you want, but the components of the all-in price are the security price plus the value of the servicing rights. Admittedly, there are some legitimate valuation differences for excess servicing, because of individual company cost-structure differences, etc.
Mortgage industry vendors have a vested interest in keeping the valuation process as esoteric as possible to justify their fees, but most of the valuation components are a guessing game anyway, and precision is impossible to achieve. They guess at prepayment and call it ‘stochastic’ analysis – but it doesn't change the fact that predicting prepayment speeds is a guessing game.
There is a school of thought that the servicing being produced today may well be worth eight to 10 times the service fee. For many years, a service fee that was a multiple of six to seven was pretty standard – this would be a reasonable and probably conservative valuation in today's environment.
The time is ripe for a correspondent lender to challenge the leaders for market share, with very little downside risk. Since the leader is only paying a four multiple at most, setting a pricing model at these levels still leaves a generous upside.
By following this strategy – coupled with no legacy issues and the underwriting portal being broader – increased market share could easily be achieved. Participants would be buying the full spectrum of loan products and risk profiles, not just the riskier loans they are buying through their current model.
Many lenders that are now either retaining servicing, or preparing to do so, would be more open to selling some or all of their production because they could achieve more of the real economic value from their loans, and keep cashflows consistent.
John J. Jacobs is senior vice president of secondary and capital markets at Patriot Bank Mortgage in Houston. He can be reached at (713) 800-1596.
