Modeling Mortgage Cash Flows Residential mortgages are complex financial instruments. While they are, at their heart, a fixed income instrument with a face amount and a fixed or a floating rate of interest, the ability of borrowers to voluntarily prepay at any time adds significant complexity.  This prepayment option can be triggered by an economic incentive to refinance into a lower interest rate, by a decision to sell the underlying property or by a change in life circumstances leading the borrower to pay off the mortgage but retain the property. The borrower also has a non-performance option. Though not usually exercised voluntarily, forbearance options made available to borrowers in response to Covid permitted widespread voluntary exercise of this option without meaningful negative consequences to borrowers. This non-performance option ranges from something as simple as a single late payment up to cessation of payments entirely and forfeiture of the underlying property. Forbearance (a payment deferral on a mortgage loan permitted by the servicer or by regulation, such as the COVID-19 CARES Act) became a major factor in understanding the behavior of mortgage cash flows in 2020. Should a loan default, ultimate recovery depends on a variety of factors, including the loan-to-value ratio, external credit support such as primary mortgage insurance as well as costs and servicer advances paid from liquidation proceeds. Both the prepayment and credit performance of mortgage loans are estimated with the use of statistical models which draw their structure and parameters from an extremely large dataset of historical performance.  As these are estimated with reference to backward-looking experience, analysts often adjust the models to reflect their experience adjusted for future expectations. Investors in GSE-guaranteed mortgage pass-through certificates are exposed to voluntary and, to a far less extent, involuntary (default) prepayments of the underlying mortgages.  If the certificates were purchased at a premium and prepayments exceed expectations, the investor’s yield will be reduced.  Conversely, if the certificates were purchased at a discount and prepayments accelerated, the investor’s yield will increase.  Guaranteed pass-through certificate investors are not exposed to the credit performance of the underlying loans except to the extent that delinquencies may suppress voluntary prepayments. Involuntary prepayments and early buyouts of delinquent loans from MBS pools are analogous to prepayments from a cash flow perspective when it comes to guaranteed Agency securities. Investors in non-Agency securities and whole loans are exposed to the same prepayment risk as guaranteed pass-through investors are, but they are also exposed to the credit performance of each loan. And MSR investors are exposed to credit risk irrespective of whether the loans they service are guaranteed. Here is why. The mortgage servicing fee can be simplistically represented by an interest-only (IO) strip carved off of the interest payments on a mortgage. Net MSR cash flows are obtained by subtracting a fixed servicing cost. Securitized IOs are exposed to the same factors as pass-through certificates, but their sensitivity to those factors is magnitudes greater because a prepayment constitutes the termination of all further cash flows – no principal is received.  Consequently, returns on IO strips are very volatile and sensitive to interest rates via the borrower’s prepayment incentive. While subtracting fixed costs from the servicing fee is still a common method of generating net MSR cash flows, it is a very imprecise methodology, subject to significant error. The largest component of this error arises from the fact that servicing cost is highly sensitive to the credit state of a mortgage loan. Is the loan current, requiring no intervention on the part of the servicer to obtain payment, or is the loan delinquent, triggering additional, and potentially costly, servicer processes that attempt to restore the loan to current? Is it seriously delinquent, requiring a still higher level of intervention, or in default, necessitating a foreclosure and liquidation effort? According to the Mortgage Bankers Association, the cost of servicing a non-performing loan ranged from eight to twenty times the cost of servicing a performing loan during the ten-year period from 2009 to 1H2019 (Source: Servicing Operations Study and Forum; PGR 1H2019). Using 2014 as both the mid-point of this ratio and of the time period under consideration, the direct cost of servicing a performing loan was $156, compared to $2,000 for a non-performing loan. Averaged across both performing and non-performing loans, direct servicing costs were $171 per loan, with an additional cost of $31 per loan arising from unreimbursed expenditures related to foreclosure, REO and other costs, plus an estimated $58 per loan of corporate administration expense, totaling $261 per loan. The average loan balance of FHLMC and FNMA loans in 2014 was approximately $176,000, translating to an annual base servicing fee of $440. The margins illustrated by these figures demonstrate the extreme sensitivity of net servicing cash flows to the credit performance of the MSR portfolio. After prepayments, credit performance is the most important factor determining the economic return from investing in MSRs.  A 1% increase in non-performing loans from the 10yr average of 3.8% results in a $20 per loan net cash flow decline across the entire portfolio.  Consequently, for servicers who purchase MSR portfolios, careful integration of credit forecasting models into the MSR valuation process, particularly for portfolio acquisitions, is critical. RiskSpan’s MSR engine integrates both prepayment and credit models, permitting the precise estimation of net cash flows to MSR owners. The primary process affecting the cash inflow to the servicer is prepayment; when a loan prepays, the servicing fee is terminated. The cash outflow side of the equation depends on a number of factors:

1. First and foremost, direct servicing cost is extremely sensitive to loan performance. The direct cost of servicing rises rapidly as delinquency status becomes increasingly severe. Direct servicing cost of a 30-day delinquent loan varies by servicer but can be as high as 350% of a performing loan. These costs rise to 600% of a performing loan’s cost at 60 days delinquent.
2. Increasing delinquency causes other costs to escalate, including the cost of principal and interest as well as tax and escrow advances, non-reimbursable collateral protection, foreclosure and liquidation expenses. Float decreases, reducing interest earnings on cash balances.
   

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   Source: Average servicing cost by delinquency state as supplied by several leading servicers of Agency and non-Agency mortgages.

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