DEFINITION of Mortgage Excess Servicing
Mortgage excess servicing is the percentage of the monthly cash flow that remains after the cash flow has been divided into a coupon and principal payment for the mortgage backed securities (MBS) holder. This servicing fee typically goes to the servicer of the loan and is possibly a guarantee fee for the underwriter of the MBS.
BREAKING DOWN Mortgage Excess Servicing
For example, in a typical MBS deal, if the interest rate on a mortgage is 8%, the MBS holder might receive 7.5%, the servicer of the mortgage receives 0.25% and the MBS underwriter gets 0.15% This leaves the remaining 0.10% (8% - 7.5% - 0.25% - 0.15% = 0.10%) as excess servicing.
Like an MBS, excess servicing is subject to prepayment and extension risk. When excess servicing is priced, it is valued based on an estimate of how long the annuity will last. This must be estimated since it cannot be known for certain when a mortgage borrower might refinance or otherwise pay-off his or her mortgage. The value of excess servicing can change dramatically when interest rates change, because changes in current interest rates relative to the interest rate on the mortgage determine how long the annuity of excess servicing associated with that mortgage might last.
Where Mortgage Excess Servicing Comes From
Mortgage excess servicing may be a result from the handling of mortgages that are bundled by the originator, and then sold. If the buyer does not service the loan themselves, they might enter into servicing agreement possibly with the originator or a third party. Under such an arrangement, the servicer will typically retain the right to receive part of the interest payments made by the borrowers, with respect to the overall pool of mortgages being serviced.
A mortgage serving spread is the amount of interest retained by the servicer, and is regarded in part by the servicer as a form of reasonable compensation for the services that were performed. If there is a portion of a mortgage servicing spread that exceeds what could be deemed reasonable compensation for services performed, this is called the excess servicing spread and would represent a continuing investment in the interest portion of an underlying mortgage pool.
The Internal Revenue Service (IRS) has previously ruled that ownership of certain mortgage excess servicing spreads would constitute a real estate asset and thus income from the excess servicing spreads would be treated as interest on obligations secured by mortgages on real property. This ruling was deemed applicable for real estate investment trusts for tax purposes.