OREANDA-NEWS. The likely drop in U. S. mortgage rates following Brexit will hurt valuations for some U. S. residential mortgage servicers, according to Fitch Ratings. This comes on the heels of previous mortgage servicer right (MSR) valuation declines that already took place in the first quarter of this year.

Not all U. S. residential mortgage servicers will be impacted equally. MSR-holding entities with more interest rate sensitive portfolios would be likely to feel the Brexit effects in terms of earnings and the ability to finance MSRs. This would most likely manifest in accelerated refinance-driven servicer portfolio runoff. That said, Fitch does not include MSRs in its calculation of core capitalization ratios for mortgage servicers, so from this perspective the rating impact would be limited.

Independent non-bank servicers that do not have associated origination platforms (or where originations lack sufficient scale) and service mostly performing loans are most exposed to MSR volatility stemming from a lower rate environment where prepayments may be higher.

Some entities actively employ hedging techniques in an effort to reduce the financial impact of lower mortgage rates on their MSR portfolios. A closer look by Fitch shows that non-bank servicers are generally less active than banks in applying financial hedges against MSR valuation volatility risk. This is due in part to the required infrastructure to effectively employ a comprehensive hedging strategy. Fitch also recognizes that servicing hedging is imperfect, as high correlation is not easily achieved.

Servicers that also originate mortgages have a type of 'natural hedge' from the additional revenue brought in by the production of new loans, which may help offset MSR valuation declines. The ability of the originator/servicer to 'recapture' borrowers that are refinancing is crucially important. Also, some non-bank servicers specialize in servicing underperforming loans that tend to be relatively less responsive to mortgage market rate movements and therefore have less MSR valuation volatility.

MSRs are not actively traded in an open market with readily observable prices. Typically valuation models are used to calculate the present value (PV) of future cash flows when determining the value of this asset for financial reporting purposes. Key MSR PV assumptions usually include:

--Expected loan life - driven by prepayment rates;

--Servicing fee;

--Ancillary income and late fees;

--Costs to service;

--Loan amount;

--Performing loan rate; and

--Discount rate.

MSR valuation approaches can also include float value and inflation rates. However, out of all of these assumptions, prepayment rates are typically the most difficult to predict and introduce the greatest amount of volatility into MSR PV calculations. As it turns out, prepayment rates would be the most significantly influenced by Brexit.

Holders of MSRs use either the 'amortization' or the 'fair value' method to calculate their MSR values. The amortization method results in less volatility in earnings than the fair value method. If the latter method is chosen, the MSR's are measured at fair value each reporting period and the changes are reflected in earnings in that period. This can be impactful when mortgage rates move dramatically and MSR holdings make up a significant portion of an entity's assets.

Fitch will continue to monitor the effects of the interest rate environment on the US residential mortgage servicing industry. In particular, though, Brexit-related market rate movements are likely to pressure the financial performance and activity of servicers who have struggled with the heightened regulatory environment and ensuing higher servicing costs.