by Tanta on 3/27/2007 10:19:00 AM

Fitch has a new publicly available Special Report, Impact of Financial Condition on U.S. Residential Mortgage Servicer Ratings. It identifies a high-risk class of servicers and points to some of the sources of increased risk:

To date, the financial difficulties of the various parties have been caused mainly by liquidity, overcapacity, margin pressure and poor asset quality, all of which are directly origination/ seller focused. However, for servicers who are captive to an origination shop and/or issuer, and who do not have either a diversified product mix or a financially strong parent or partner, difficulties experienced at a corporate level will undoubtedly impact the servicing operation, eventually if not immediately. For third-party subprime servicers, this impact is less. However, these servicers could also experience a loss of new loan volume, as well as the potential for higher default levels in current portfolios. Much of this increase could be caused by the defaulting subprime borrowers being unable to obtain refinancing, both due to flat or decreasing home price appreciation and the tightening of credit standards on new originations. Any servicer, whether captive or third party, which has predominantly subprime credit quality loans in portfolio, could find its timelines and overall cost to service facing increased levels not seen in recent history.
. . .
The major areas of concern for some originators/issuers of subprime products, and therefore their captive servicers, are liquidity, overcapacity, margin pressure and asset quality. Although in recent periods some reduction in liquidity capacity could be managed, based on declining volumes, current liquidity trends are primarily a result of tripped covenants and liquidity providers’ rapidly declining risk appetite. To date, when covenants have been tripped, the profitability covenants are frequently the first to be triggered. Previously, the liquidity providers were more willing to extend maturities for a short period in order to provide a company an opportunity to repair the breach. It now appears that these banks’ flexibility is declining, and margin calls have begun in earnest. Margin calls, combined with early payment defaults (EPDs), have eroded some firms’ financial position to the point that several are on the brink of bankruptcy, necessitating them to stop funding new originations and/or seek potential sale or partnership arrangements.

In recent years the industry has seen new participants enter the market, which has led to overcapacity. This overcapacity has begun to ease, with several players exiting the market, or at a minimum tightening underwriting guidelines and eliminating certain products. More consolidation is expected before the industry will be appropriately sized for expected ongoing mortgage market dynamics. In addition, extremely aggressive competition, rising funding costs and slowing origination volume have pressured profitability. Margins on whole loan sales have sharply deteriorated due to supply/demand imbalances, as well as the declining risk appetite among investors. Aggressive competition has also been a contributor to the deterioration of asset quality as evidenced by EPDs and rising default rates on subprime loans. . . .

Currently servicers are challenged with rising expenses, shrinking margins and fluctuating origination, and therefore portfolio, volumes. In addition, servicers are dealing with the complexities of natural disasters, compliance to varying federal and state regulations, as well as servicing a number of new and unique products. Further, the increasing delinquency environment may stress those servicers that are not adequately staffed or prepared to manage seriously delinquent loans with flexible default management solutions.

The entire report is fairly brief—five pages—and certainly worth a read. Bear in mind that the “historical” experience in the mortgage industry is that servicing income is counter-cyclical: you make more on servicing in those periods in which you make less on originations. History may be refusing to repeat itself for some people right when that would be convenient.