Preliminary outlooks for the major U.S. banks on their mortgage servicing rights (MSRs) doesn’t look good, and it devastate the earnings of the banks for the quarter. Especially vulnerable are Bank of America Corp. (NYSE:BAC), JPMorgan Chase & Co. (NYSE:JPM), Citigroup Inc. (NYSE:C) and Wells Fargo & Co. (NYSE:WFC), who combined possibly may have to take writedowns on $55 billion of mortgage-collection contracts they service.
Last quarter, MSRs and fees helped the banks to what passed for decent growth. That is likely to change very quickly as earnings reports come out.
The four largest U.S. banks by assets handle 5.9 trillion in U.S. mortgages or 56 percent of the mortgage contract market. Expectations are they will have to write them down this quarter, as analysts say they are highly overvalued at this time.
Technically the banks are required to attach a value to them by measuring it according to what a home would sell for at fair-market value. But as bank industry watchers and insiders know, the fact that there is no trading on MSRs makes it impossible to know if the value the bank applies is in fact an accurate assessment of the worth the rights.
As one analyst said, “It’s an accounting game. The deeper you get into the subject, the more items you find that are impossible to determine, and therefore it becomes a give up. Whatever they want to show, they show.”
Add to that the way banks are identifying and reporting foreclosures and those behind on payments, and you have a situation that can’t be measured as far as the real performance of the bank. I think they are just fine with that at this time, and the uncertainty and confusion helps them gain time and keep consumers and shareholders off their back while they hope things turn to the better.
Back to MSRs, they are largely priced from the activity of borrowers, who will refinance when interest rates are low, effectively causing the value of MSRs to decline.
Banks will fight that with hedging moves using highly volatile derivatives, which themselves are difficult to understand by even the most savvy financial experts.
The bottom line for banks servicing MSRs is they’re unpredictable, and shareholders and others interested in the financial health of the banks are unable to make any assessment as to the viability of these contracts as they apply to profits or losses.
With the market drying up, MSRs, which are considered Level 3 assets, banks can just about apply any value they want to put them in positive light, no matter what they’re performance it. Level 3 is a term used in accounting which means the value of the security isn’t able to be determined.
The other problem associated with valuations of MSRs in a slow market is how to hedge them properly, which essentially is impossible to do, adding to the unattractiveness of them as a banking service and asset.
Major banks’ profits consequently are expected to fall this quarter as earnings reports come out, and a lot of that is based upon the loss in value of MSRs and the costs of hedging associated with them.
This will also make it impossible to know the real health of the major banks that have substantial exposure to MSRs, which could cause some stock price backlash because of the inability to make that determination. Not all banks are exposed to MSRs in this way, but the larger ones definitely are, and the four majors above are in a big way.
