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Who's Afraid of Mortgage Servicing Rights?


The term mortgage servicing right or "MSR" generally describes a party's contractual rights with respect to servicing or controlling the servicing of a pool of mortgage loans owned by others, including the entitlement to receive servicing compensation. There are a number of risks involved with investing in MSRs, including accurately estimating the prepayment rates of the underlying mortgages and managing the related swings in valuation due to movements in benchmark securities such as the 10-year Treasury. For example, in October 2007 Countrywide recorded a write-down of nearly $1 billion on its MSR which at the time had a book value of $18 billion on a balance sheet of $200 billion in assets, meaning that virtually the bank’s entire capital position was essentially represented by the mortgage servicing asset.

The largest risk facing an investor in MSRs and/or a creditor holding exposure to MSRs as collateral, however, is that the ownership of the asset may be “terminated” by a government agency or investor. This risk is binary for the parties at interest and can be particularly significant in the case of non-bank lenders and loan servicers (“seller/servicers”), because as asset managers for loans owned by third parties, the MSR frequently is the only significant asset on the company’s balance sheet.

While the academic literature regarding MSRs is limited, those sources that are available most often focus on the risk to the borrower or home owner in the event of interruption. From a credit and business perspective, however, the prospect of an interruption or involuntary termination of servicing rights raises potentially catastrophic risks to counterparties and investors. This idiosyncratic risk of servicing termination is a function of both quantitative factors such as the financial performance of the seller/servicer and qualitative factors such as management, internal systems and controls, compliance and operations. Indeed, in many cases the human resources function of a seller/servicer is one of the most important internal functions in the entire enterprise.

All of the federal housing agencies, including government sponsored entities such as Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA), have the unilateral right to transfer the servicing of loans and/or securities they guarantee. The GSEs and GNMA also have approval rights over the transfer of MSRs, again associated with securities that these entities guarantee. All three agencies have established review procedures for transfers of MSRs since the 2008 financial crisis. FNMA, for example, has published a Servicing Transfers Overview that sets forth criteria for the approval of MSR transfers.

In addition, investors have consent rights to servicing sales and transfers for non-agency mortgages, but the requirements of private transfers of servicing are onerous. “As a condition to providing the consent,” notes a 2015 report by the Federal Reserve Board and other bank regulatory agencies, “investors have historically required that the buyer of the MSAs assume direct recourse liability for origination and servicing defects, regardless of whether that buyer, as the new servicer, originated the loan or caused the servicing defect.”

In general, the reasons for an involuntary termination of servicing rights primarily turn on quantitative factors, in particular the financial soundness of the servicer. Virtually all of the servicing transfers seen in recent years have occurred because of financial difficulties at the seller/servicer, but the reasons for a transfer vary. In the case of GNMA, transfers are usually initiated out of concern that the seller/servicer has liquidity problems and cannot either 1) maintain timely payments to bond holders and/or 2) repurchase defaulted mortgages out of GNMA pools. In the case of FNMA and FHLMC, on the other hand, servicing transfers have been far more rare and are usually motivated by concerns about the ability of the seller/servicer to service the loans and engage in effective loss mitigation of loan defaults.

It is important to understand that GNMA guarantees only the pass-through payments to security-holders, not the credit performance of the underlying loans. The loans which underlie a GNMA security are guaranteed by the Federal Housing Administration (FHA), Veterans Administration (VA) or US Department of Agriculture (USDA). But unlike the GSEs, GNMA has no balance sheet with which to fund advances to bond holders in the event that a seller/servicer suffers liquidity problems. More, GNMA cannot purchase troubled loans or MSRs, and thus the agency tends to be very proactive when it determines that a seller/servicer is in financial distress.

Another reason for the GSEs or GNMA to initiate a servicing transfer is reputational risk. Negative publicity with respect to a seller/servicer can lead to reputational harm, which can have adverse effects on other lines of business, the availability of funding from counterparties and on a firm's MSR portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some bank and non-bank institutions to leave or divest of their mortgage servicing activities.

For example, in the case of Ocwen Financial (NYSE:OCN), publicity related to its operational problems and related action by the states of New York and California led to “voluntary” servicing transfers of GSE and GNMA MSRs in 2015 to other entities including Nationstar (NYSE:NSM) and JPMorgan Chase (NYSE:JPM). These transfers were actively encouraged by regulators and subject to approval by FNMA and the Federal Housing Finance Agency (FHFA).

In a 2015 comment letter from the American Bankers Association to the MSR Task Force of State Bank Supervisors, the trade group noted:

“If a non-bank servicer were to fail, significant questions could arise regarding the capacity of the market to financially absorb and operationalize the transfer of an unprecedented number of servicing rights. We are also concerned about the potential gaps in borrower service and borrower confusion that could occur in this situation.”

The Risks of Servicing Transfers

First and foremost, the involuntary termination of servicing can result in a total loss to the owner of the MSR and also cause losses to any creditors with a security interest in the intangible asset or the underlying loans. In the event of an involuntary termination initiated by one of the federal housing agencies, the MSR asset essentially disappears from the balance sheet of the former servicer, who receives no compensation from the new servicer. This potential for a total, binary loss with respect to the MSR due to a termination and involuntary transfer has negatively colored the view of these assets within the mortgage finance and credit communities.

As discussed below, uncertainty as to how such a transfer process would work in the event of default of a servicer has historically made lenders reluctant to lend against MSRs or loan collateral tied to an MSR, especially for GNMA exposures. This situation has improved recently, however, with changes made by GNMA in its acknowledgement agreement. The new agreement provides some comfort to investors and lenders that GNMA “won't interfere with financiers' rights to servicing,” reports National Mortgage News, “so long as Ginnie is given all the information it needs to be sure the bond payments that the agency insures flow through to investors.”

The changes to the GNMA acknowledgement agreement made at the end of 2016 have had a tangible and positive impact on how investors and lenders view GNMA MSRs. Whereas a year ago, lenders were reluctant to lend more that 50% against GNMA MSRs or advances for distressed loan servicing, today the loan rates vs GNMA MSRs and loan collateral advance rates have climbed into the 70s vs 90% for FNMA and FHLMC exposures. In the first quarter of 2017, asset-backed securities transactions using GNMA MSRs as collateral have been completed by PennyMac Mortgage Investment Trust (NYSE:PMT) and Freedom Mortgage.

Involuntary termination of servicing have been extremely rare and have usually involved smaller banks and nonbank servicers that have experienced financial difficulties or failed. There have been few forced transfers of mortgage servicing by the FNMA, FHLMC or GNMA involving a mortgage servicer that was still in operation. In cases where the loan servicer encounters financial problems, however, the risk of termination rises dramatically. The Federal Reserve Board noted in a report to Congress:

“Mortgage servicing is governed by regulations and contracts that can pose significant legal and compliance risks. Various federal and state agencies' rules and regulations address mortgage servicing standards, including consumer protections. In addition, the GSEs and Ginnie Mae require servicers to comply with guidelines to service loans guaranteed by those entities, while separate contractual provisions govern the servicing of loans in private-label MBS. Mistakes or omissions by servicers can lead to lawsuits, fines, and loss of income. Use of subservicers or other contractors can compound this risk. In addition, when a servicer does not comply with the standards established by the GSEs or Ginnie Mae, these entities can confiscate the servicing, forcing the servicer to charge off the value of the MSA.”

“Moreover, negative publicity can lead to reputational harm, which can have adverse effects on other lines of business and on a firm's MSA portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some banking institutions to leave or divest from their mortgage servicing activities.”

With all of these caveats enumerated, however, it is important to remember that most mortgage servicing portfolios have enormous stability and considerable intrinsic value, primarily because when managed properly they throw off large amounts of cash and can thus be readily transferred in the event such action is required.

Case Study: Taylor Bean Whittaker

In 2002, FNMA terminated Taylor Bean Whittaker’s (TBW) status as an approved seller/servicer after discovering significant fraud in the company’s loan origination and sales practices. FNMA, however, did not formally advise Freddie Mac, its regulator, the FHA or other interested entities about TBW's termination or the reasons for the action. Indeed, FNMA instead entered into an non-disclosure agreement with TBW and then took active steps to conceal the reasons for the termination. Following its termination by FNMA, TBW dramatically increased the volume of its business with FHLMC and GNMA.

By 2009 when it filed for bankruptcy protection, TBW serviced a mortgage portfolio of approximately 512,000 loans with an aggregated unpaid principal balance (UPB) exceeding $80 billion. The 2009 bankruptcy of TBW resulted in the confiscation by GNMA of an MSR representing $26 billion in unpaid principal balance (UPB) of loans. The reason for the action was that the financial failure of the entity placed GNMA at risk of default on its insured securities. In a September 2014 report, the Inspector General of GNMA noted:

“The ultimate failure, of course, is the inability of an issuer to pass through payments to security-holders or to otherwise demonstrate a lack of compliance so significant as to render it unfit to maintain its nominal ownership of the MSRs. Historically, such failures have resulted in Ginnie Mae’s declaration of a default, with the accompanying extinguishment of an issuer’s rights to the MSRs and termination of approval status. In such cases, the MSRs become government property and are serviced on behalf of Ginnie Mae by a third party subservicer.”

On August 14, 2009, Colonial Bank, Montgomery, AL, TBW’s insured depository, was closed by the Alabama State Banking Department. The Federal Deposit Insurance Corporation (FDIC) was named Receiver and sold the bank’s branches to BB&T (NYSE:BBT), but the FDIC insurance fund ultimately took a roughly $3 billion loss. Also, Deutsche Bank (NYSE:DB) and BNP Paribas (NYSE:BNP) together lost over $1.5 billion, due to the fraud related to TBW’s bogus commercial paper operations, which were conducted out of a non-bank subsidiary of the group.

In 2010, GNMA bought over $4 billion of non-performing TBW loans out of its guaranteed MBS pools and increased its applicable reserve for losses by $720 million to prepare for anticipated losses. The Federal Housing Administration (FHA) and GNMA Mae eventually lost hundreds of millions on defective loans placed in MBS pools that were guaranteed by FHA. FHLMC lost over a billion dollars on defective loans that TBW sold it, after TBW's frauds were uncovered and the firm ceased operations.

Voluntary Servicing Transfers

The failure of TBW was an extreme event that involved deliberate acts of fraud, acts which ultimately saw the head of the company prosecuted criminally. The losses due to TBW, however, were actually exacerbated because FNMA did not take active steps to see that the bank’s fraudulent operations were promptly shut down by prudential regulators.

In the case of the bankruptcies of both TBW and ResCap, however, the loan servicing operations that remained continued to operate in due course post-filing and, indeed, under the protection of the Bankruptcy Court, which rightly saw the MSRs and whole loans as valuable assets of the bankruptcy estate that warranted protection. Even though the housing agencies suffered losses due to the fraud at TBW, the GNMA servicing assets were eventually sold voluntarily. All of the FHA, VA and Rural Housing Services loans that were current were transferred to Bank of America (NYSE:BAC). Delinquent loans were transferred to either Saxon or Ocwen.

In other cases where a seller/servicer merely encounters financial difficulties, it seems reasonable to expect based upon past experience that FNMA, FHLMC and GNMA Mae would likely acquiesce in the voluntary transfer of servicing, as in the case of Ocwen in 2015. Again, the key question in the case of GNMA is whether or not the seller/servicer was able to continue 1) making payments to bond holders and/or 2) fund the repurchase of defaulted loans. With the GSEs, the issue is a more general concern about liquidity in the context of loss mitigation activities on defaulted loans.

Both the 2009 bankruptcy of TBW and the 2012 ResCap bankruptcy resulted in the orderly transfer of mortgage servicing and loan portfolios with the consideration flowing to the respective estates. Ocwen Financial Corp and Walter Investment Management Corp (NYSE:WAC) ultimately prevailed in a bankruptcy auction for the ResCap mortgage business with a $3 billion bid that topped rival Nationstar Mortgage Holdings (NYSE:NSM). Ironically, the acquisition of the ResCap MSR caused significant operational problems for Ocwen three years later.

Neither the bankruptcy of TBW nor ResCap created a financial panic or broader problems in the financial markets. In both cases, the successful use of bankruptcy suggests that mortgage servicing is inherently stable and that FNMA, FHLMC and Ginnie Mae will acquiesce in a voluntary restructuring of a seller/servicer so long as 1) creditors are kept at bay via an orderly bankruptcy or receivership process and 2) the servicers have sufficient liquidity to maintain in process payments to bond holders and other creditors, in the case of GNMA, and to fund loss mitigation activities, in the case of both GNMA and the GSEs.

Conclusion

While the potential risk of termination of a mortgage servicing portfolio is very real, in reality the chances of such an occurrence seem to be relatively small. A big part of the reason for the remoteness of involuntary mortgage transfers seems to be the fact that all of the housing agencies carefully monitor the financial stability of the seller/servicers operating in the markets in which they operate. Also, financial problems at a seller/servicer that result in the involuntary termination of servicing rights can cause significant problems for consumers and thus has become a major area of concern for federal regulators.

Preserving the value of the MSR is a key consideration in any situation where the liquidity or financial strength of the seller/servicer is in question. As a result, all of the housing agencies tend to take a very proactive approach to surveillance of seller/servicers and require voluntary transfers when necessary, especially for smaller seller/servicers. In the rare cases where a servicer has filed bankruptcy, both the courts, the federal housing agencies and federal bank regulators have worked together to achieve a smooth and voluntary transfer of servicing with consideration paid to the original MSR holder.

Despite the ugly details around both bankruptcies, the cases of TBW and ResCap illustrate the fact that a loan servicing business is stable and can operate in bankruptcy. The fact that the MSR is often the most valuable asset of a seller/servicer seems to have made the federal courts and corporate creditors willing to work to achieve an orderly resolution in the event of a bankruptcy by a seller/servicer.

In general, when assessing the potential risk of the involuntary transfer of mortgage servicing, it seems obvious that investors, analysts and regulators should pay close attention to quantitative factors such as the financial soundness and sources of liquidity of the seller/servicer. Another area of interest should be the management team and its ability to assess and control risks to the enterprise. Any evidence of operational problems at a seller/servicer are obviously a red flag for investors and counterparties.

But perhaps the biggest issue in assessing a mortgage servicer is operational, namely whether the seller/servicer can effectively manage the compliance, training and human resources challenges in servicing residential loans. As we have seen with Ocwen and other large legacy seller/servicers including banks and nonbanks, failure to effectively manage the loan servicing process can result in fines and sanctions, public censure and reputational risk, and a cascade of events that can even threaten the ability of the enterprise to remain a going concern.

The bottom line is that the most egregious example of termination of mortgage servicing rights, TBW, involved deliberate acts of fraud and criminality. Most of the other events shown in the table of GNMA terminations of mortgage servicing involved smaller banks and nonbank servicers that encountered financial difficulty and subsequently failed or were sold. In those cases where a large seller/servicer has filed bankruptcy, the transfer process for MSRs has been smooth and the rights of creditors have been protected, suggesting that outside of cases where fraud is present the overall risk to investors and creditors is relatively manageable given a surveillance program that follows the criteria outlined above.

A version of this commentary with footnotes and appendices can be found on SSRN

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2936422

#Finance #Mortgage #Banking

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© 2003-2020 | Whalen Global Advisors LLC  All Rights Reserved in All Media | ISSN 2692-1812