A lattice valuation model of mortgage servicing rights and implications for bank loan portfolio allocation

The primary interest of this study is to evaluate the price of mortgage servicing rights using an option-based model of mortgage servicing rights and to determine the optimal mix between two different degrees of risky servicing contracts in terms of housing-price volatility on behalf of mortgage servicers.; The value of a servicing contract depends upon the net earnings that account for the revenue received to cover the costs paid to fulfill the servicing operations. This paper, therefore, documents one way of modeling servicing costs and further examines the impact of these servicing costs on the value of the mortgage servicing rights. This study also uses a lattice approach to compute the value of the mortgage contract at any particular node in two interest rate/house value spaces and also the value of mortgage servicing rights at any particular node and additionally it uses Monte Carlo method to examine how portfolio value changes and how to rebalancing a servicing portfolio.; This paper further investigates how the portfolio value changes with respect to changes in parameters used in simulation technique. The implication of this paper is potentially useful for mortgage banks to price mortgage servicing rights with two embedded options, prepay and default, in mortgage and how to help manage the appropriate allocation between two types of servicing contracts into their servicing portfolio under various economic environments.