The Biden tax proposal will crush the mortgage servicing rights market

Even as new lending volumes for 1-4 family mortgages fall and the industry turns its attention once again back to expense management instead of growth, the market for mortgage servicing rights is on fire. As refinance applications decline, the value of monthly MSR cash flows is rising fast and may challenge peaks since several years ago.

A number of banks have entered the market in the past month to offset runoff of loans due to prepayments, according to SitusAMC. The U.S. banking industry experienced a significant decline in the total portfolio of 1-4s during 2020, as well as servicing for third parties. In Q1 2021, total 1-4s serviced for others by U.S. banks dropped below $3 trillion while non-bank servicers are approaching $6 trillion

The growing crowd of banks, mortgage banks and investors seeking to buy servicing assets has pushed valuations up above 5x annual cash flow from the servicing strip, a price level that make many veteran operators shake their heads in disbelief. On a conventional mortgage servicing asset, for example, a 5x multiple translates to a valuation of roughly 125bps. This level is considerably above the cost of creating the asset and the fair value of similar MSRs reported by many public companies.

Last week, for example, Ocwen Financial (NYSE:OCN) struck a deal to purchase $48.3 billion of Fannie Mae/Freddie Mac MSRs from AmeriHome Mortgage, which was acquired earlier this year by Western Alliance Bancshares (NYSE:WAL). Ocwen had acquired servicing assets from Texas Capital Bank earlier in the year.

Ocwen’s PHH subsidiary will pay roughly $600 million for conventional servicing assets supported by $48 billion in unpaid principal balance of 1-4 family loans. If we divide the consideration by the UPB, the result is a valuation of about 125bp for the MSRs acquired or precisely 5x annual servicing income. Of note, Western Alliance is financing the purchase, thus the top-performing bank exchanges an arguably overvalued MSR for a financing asset.

The positive environment in the market for MSRs may not last, however. The Biden Administration has proposed a new alternative minimum tax structure on book income. The Biden tax proposal could negatively impact the value of independent mortgage banks, the market for MSRs, and severely impair the value of servicing assets owned by banks, non-banks and investors.

During the 2020 campaign then-candidate Biden proposed an alternative minimum tax of 15% on book income for companies with a net income of $100 million or more. The proposal was most recently adjusted by now-President Biden with the release of the “Made in America” proposal’s tax components. The most recent proposal adjusts the application threshold of the AMT to companies with a net income of $2 billion or more.

The AMT would require certain companies to make a new tax calculation on book income and pay a minimum tax of 15 percent, even on assets and business activity that has not yet generated any taxable income in cash terms. This calculation would ignore previous losses, so even companies with large net operating losses would be forced to pay the minimum tax.

During the congressional debate on tax cuts in 2017, a proposal was advanced that would have eliminated the exemption for MSRs, which accrue income over time. The Biden tax proposal would tax MSRs when the mortgage note is sold, forcing mortgage lenders to pay taxes on income they have not yet received. The negative impact on the value of existing and future MSRs owned by banks and nonbanks alike could be disastrous.

“An industry concern during the debate on the bill related to a provision, which would have eliminated the tax deferral on the creation of mortgage servicing rights,” Mike Fratantoni of the Mortgage Bankers Association wrote in a recent op-ed column.

“MSRs are booked as a balance sheet asset when loans are sold into the secondary market and show as book earnings at that time. However, if the servicing is retained, the lender does not receive any cash income when the MSR is created. The tax deferral in the current code recognizes this difference between book and tax income, taxing servicing income over time as the cash arrives.”

The Biden tax proposal to impose a corporate AMT is part of a larger democratic attack on home ownership that includes an increase in the taxes on capital gains as well as an end to 1031 exchanges for the sale of property. I outlined the impact of these proposed changes on family farms and small investors in residential real estate in a recent blog post forThe Institutional Risk Analyst.

President Biden is seeking higher taxes on real estate transactions with gains of more than $500,000, a target aimed directly at the heart of small real estate investors, family farmers and owner-occupied businesses. In combination with his plans to eliminate step-up basis on the resolution of estates, the Biden tax proposal will greatly increase the cost of farmland and thus food prices, property prices and rental costs in some markets.

The AMT will have a unique and negative impact on mortgage lenders and servicers – particularly IMBs. The negative treatment of MSRs under the AMT will force IMBs to sell most servicing assets when the mortgage note is sold to investors in the bond market. Since IMBs are large and long-term holders of MSRs and today service two-thirds of all 1-4 family mortgages, the Biden AMT could negatively impact the availability of credit for all consumers. Indeed, this is precisely the objective of the cynical and deliberate Biden attack on the American dream of home ownership.

One issuer tells NMN that the AMT may accelerate tax exposure for banks and IMBs and change how servicers and investors view large positions in MSRs. The ill-considered proposal from the Biden Administration could result in depressed mortgage originations, higher costs to borrowers and less availability of credit, and perhaps even forced sales of servicing assets.

Since commercial banks apparently want nothing to do with mortgage servicing assets, in large part due to the specific advice of federal bank regulators, who would want to own the MSRs if not IMBs and large Buy Side investors? This is a question that the Biden Administration needs to answer.

Meanwhile, members of the residential mortgage industry need to immediately mobilize to kill the Biden AMT proposal and protect consumers and the mortgage sector from this unwarranted attack on home ownership.

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