Treasury Risk Management

Citigroup Treasury Risk Management

Alternative Minimum Service Fee

Reducing Risk in Hedged MSR

Mark Friedenthal MBA Secondary Marketing Committee

Citigroup June 19, 2008
 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Issues

MSR returns are extremely volatile and, at times, prohibitively

costly to hedge.
MSR is capital intensive, requiring 17.2% bank regulatory
capital (nearly 11x the capital of agency MBS). Non-bank capital
requirements may be greater.
Traditional MSR, as a Level 3 asset, lacks valuation
transparency. It is difficult for regulators, independent risk
managers, and analysts to form consistent opinions as to
accuracy and fairness of value.
Capital intensive investment and volatile returns have prompted
exits from the mortgage business, leaving the GSEs with
concentrated risk to large servicer default.

Proposal
 Servicer compensation based on constant percentage (e.g. 1%) of all of
the cash-flows of each loan. As such, the service fee would be based on
BOTH principal & interest, rather than an interest-only strip. In turn, it
would look like 1% of the MBS pool that is created (plus ancillaries).

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Mechanics

Servicer (AMSF) is in similar position to MBS investor.

Prepayments are applied on a pro-rata basis.

Requires complete conversion to new AMSF servicing

to prevent adverse selection on the part of lenders.

Excess servicing still exists as an alternative to higher

delivered coupon and agency g-fee buy up grids.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management

AMSF Construct

Alternative Servicing Fee Calculation: 1% of MBS Cash-flows

Both MSR value and total loan value remain constant

5.5% MBS $ 1bn UPB x 98 px = $980mm

Traditional 6.25%
Agency Loan

0.25% g-fee
0.25% msr MSR = 125bps x $1bn = $12.5mm
0.25% excess Excess = 100bps x $1bn = $10mm

Total Value = $1.0025bn

Fee Calculation
[1%] of MBS
cash-flows
6.00% MBS $990mm UPB x 100 px = $990mm
6.25%
AMSF Agency Loan

AMSF
(1% P&I) MSR = $10mm UPB x 100 px + ancillaries = $12.5mm
(MSR= 1% of par bond + 25bps for ancillaries)
0.25% g-fee

Total Value = $1.0025bn

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management

Cash-flows – Example

$1bn UPB, 6.25% note rate, 6.00% MBS

Prepayment Speed Total Service Fee

($MM)

CPR 25 bps 1% of MBS

0 48.7 21.7
5 29.2 17.0
10 19.3 14.6
15 13.8 13.3
20 10.5 12.5
30 6.8 11.6
40 4.9 11.2
50 3.6 10.9
 Stable Service Fee Income means reduced risk
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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Constituent’s Perspective

Servicers
 Reduced Risk
 Reduced Hedge Expense
 Possible Reduction in regulatory capital
 Improved valuation transparency and market liquidity

GSEs
 Promotes industry Stability

Investors
 Reduced mortgage rate volatility (current coupon)
 Lower gross WAC/coupon delivered
 Increased supply of higher coupon TBA
 Improved valuation transparency and market liquidity
 Concerns about servicer solicitation
 Concerns about market liquidity

Regulators/Analysts/Shareholders/Independent Risk
 Improved transparency in valuation
 Reduction in servicer net exposure

Consumers
 Expected more competitive pricing

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Less Reactivity to Interest Rates and Less Duration to Hedge

20 1

10-Yr Equiv Shorted for Hedging

10 0
-150 -100 -50 0 50 100 150
0
% Chg in Value

-1
-150 -100 -50 0 50 100 150
-10
-2
-20
-3
-30
Servicing Strip Off 5.5s
Servicing Strip Off 5.5s
-40 -4 (Equiv Mkt Val)
5.5 Passthrough 1% of 5.5 Passthrough

-50 -5
Interest Rate Change Interest Rate Change
Source: Citi. Source: Citi.

 AMSF duration is less than 25% of traditional interest-only servicing.

 AMSF convexity risk is less than 20% of traditional interest-only servicing.
 MSR Volatility Reduction
- Traditional MSR (IO) Volatility = 40% (1 σ/yr)
- AMSF (MBS) Volatility = 5% (1 σ/yr)

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Prepayments Fannie Mae 2006 Orig Yr Speeds by Servicing Fee
25

20
 The size of the servicer’s

6-Mo CPR (%)

investment (traditional 15
disincentive) does not
10 6.0% Net Coupon
materially influence 6.5% Net Coupon
prepayment speeds. 5

0
 Collateral characteristics 25 37.5 50 62.5 75 87.5
best explain prepayment Servicing Fee (bp)
behavior. Source: Fannie Mae, CPR&CDR Technologies, Citi.

 25 bp servicing fee 6.0%

coupon illustrates that
gross wac is more 6.0% Net Coupon 6.5% Net Coupon
influential than loan size, Sfee (bp) LoanSize LTV (%) CrdScore LoanSize LTV (%) CrdScore
credit score, and servicer 25 220 70 731 195 76 711
37.5 207 73 722 167 77 710
investment combined! 50 191 73 722 164 79 704
62.5 194 75 717 157 81 696
75 198 76 712 157 81 689
87.5 189 78 700 183 81 689
Source: Fannie Mae, CPR&CDR Technologies, Citi.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Will prepayment speeds on premium bonds increase?

 The overwhelming majority (90+ %) of refinances are initiated by

individuals/parties with no change in incentives due to AMSF.
- Borrowers
- Loan officers
- Mortgage Brokers
- Correspondents
- Competitors (other servicers)
 Servicer specific prepayment data is widely available. Negative publicity for
servicers with fast speeds serves as a deterrent to excessive solicitation.
- Capitalized value of ancillaries also serves as some disincentive for solicitation.
 The gross wac (for a given pass-through coupon) will be approximately 25bps
lower with AMSF, decreasing borrower refinance incentives and slowing
speeds.
 Data shows that prepayment speeds are not correlated to the size of the
servicer’s investment (disincentive to refinance).

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management

Additional Benefits

 Possible reduction in Regulatory Capital, commensurate with risk

reduction.
 Price Transparency – Asset will resemble Agency MBS (plus
ancillaries), which have observable market prices.
 Reduced probability of servicer “blow-up”.
 Servicer will focus on long-term operational efficiency instead of
hedging short-term P&L.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
What will happen to TBA liquidity?

 Pass-through market already differentiates by WAC, WAM, average

upb, geography.
- The largest contributing factor to prepayment behavior is gross
wac.

 Prior changes to TBA market have been successfully transitioned.

- GNMA II base MSR reduced from 44bps to 19bps.

 All new securitizations would be serviced in this new (and uniform)

manner, eliminating the ability for “cherry picking”.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management
Will non-agency securities be serviced using AMSF?

 The scope of this initiative begins with all Agency products. However, servicers
may incorporate this new standard in to public and private non-agency
securitizations in the future.

Will gain on sale accounting treatment change?

 Preliminary evaluation suggests that accounting treatment will remain the

same.

Will safe harbor tax status change?

 Preliminary tax evaluation suggests that the safe harbor treatment remains in
effect with AMSF.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management

Next Steps

 Validate Accounting and Tax preliminary conclusions.

 Work through Mortgage Bankers Association to flesh out logistics.
- Is 1% the appropriate size servicing fee?
- Should all products have the same fee?
- What other operational changes need to be made?
 Work with SIFMA to gain investor support.
 Include OCC, FRB, FDIC, and state regulators in development
process.

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 Alternative Minimum Service Fee
Citigroup Treasury Risk Management

Co-Sponsor Contacts

Mike Carrier Andrew BonSalle Mark Hanson

Mortgage Banker’s Association Fannie Mae Freddie Mac
mcarrier@mortgagebankers.org Andrew_bonsalle@fanniemae.com Mark_hanson@freddiemac.com
(202) 557-2870 (202) 752-3747 (571) 382-3910

Mark Friedenthal Franklin Codel Gordon Roder

Citigroup Wells Fargo AmTrust
Mark.s.friedenthal@citi.com Franklin.codel@wellsfargo.com groder@amtrust.com
(212) 559-0989 (515) 213-6508 (216) 588-5891

Kirstin Hammond Rich Bradfield Mark Engman

Flagstar Bank PHH Mortgage US Bank Home Mortgage
Kristin.hammond@flagstar.com Rich.bradfield@phh.com mark.engman@usbank.com
(248) 312-5780 (856) 917-0107 (414) 773-3838

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