Residential mortgage servicing rights have been steadily migrating to nonbanking institutions, due to regulatory changes in capital requirements imposed on banking institutions, which have caused MSRs to become an expensive asset for banks to retain on their balance sheets. Nonbanks may have their own servicing platforms or they may subcontract with a subservicer to whom they pay a subservicing fee, which is a fraction of the servicing fee to which the MSR owner is contractually entitled. As servicing continues to shift away from banks, the industry will see greater need for financed servicing for the nonbanks acquiring MSRs.
The industry should move to address these issues now before the liquidity crunch reaches a crisis point.
Many lenders are reluctant to finance MSRs, given some challenges that the asset presents. These include the actual ability to replace the servicer in the event of a servicer default, in which the servicer is stripped of the servicing for cause, or in the event of a default under the lender's financing documentation with the servicer. In addition, there is always the threat of a potential servicer bankruptcy proceeding. In a private securitization context, these challenges are multiplied by restrictions in the documents and ongoing rating agency scrutiny. Although state law, for public policy reasons, nullifies anti-assignment provisions in documents in the context of financing a right to receive payment (for example, a monthly servicing fee), the threat of a rating agency downgrading a transaction if servicing is encumbered to a third party is a concern that cannot be discounted and gives lenders pause.
There is an inherent tension in any servicing financing between the ability to pay an economic servicing fee to a servicer (or replacement servicer) for servicing the underlying mortgage loans and financing the present value of such fees. This is because regardless of whether the MSRs are sold to a third party, there will always be a subservicing fee that will need to be accounted for (either to be paid to a third party contract servicer or attributed to the servicer for the servicing function). The risk of erosion in value is compounded by mortgage loan owner's ability (or a securitization trust, in the case of private-label securitizations) to terminate a servicer for cause without any payment to the servicer.
In order to address some of these obstacles, the industry needs to reconsider its typical securitization structures to allow for financing MSRs as a permitted transaction under the documentation. This would include expanding provisions now found in many transactions that make servicing advance receivables financings possible to include the prospect of MSR financings. Among the issues to consider is whether intercreditor provisions would need to be inserted to the extent that the lender financing servicing advances is not the same lender financing the MSRs themselves. This would necessarily include addressing waterfall priorities and sharing provisions.
Typically, servicing advance reimbursements and servicing fee payments are equal in the waterfall. While there may be variations, there should be established rules for dividing cash flow among different lenders. Although the logical answer may be to have the same lender finance both the servicing advance receivables and the MSRs, this may not always be possible. The risk profile and appetite for these assets differ considerably, and not all lenders will want to finance both. However, if each lender's rights are carefully delineated, this may offer an additional liquidity source for servicers who need to monetize the servicing asset with lenders who are willing to take on greater risk than is associated with servicing advance receivables financings.
Furthermore, in order to assist in any foreclosure process, a lender financing residential MSRs should have certain contractual rights to replace a servicer, either due to a default under the lender's documentation with the servicer or due to a default by the servicer in a securitization. This would permit the lender to protect its investment in the residential MSRs. In either case, a rating agency confirmation requirement would protect the securitization and ensure that the security holders are protected. This would offer lenders some assurance of control over the asset that they finance.
In addition, there should be some attention given to whether a portion of the servicing (i.e., the excess spread) should be structured as an interest-only strip that is a security in the securitization itself. As a strip that is severable from a servicer's future performance, this interest can give a lender greater protection for a portion of the proceeds attributable to the MSRs in the event of a servicer bankruptcy proceeding or other event that could otherwise impair the servicing asset. While a lender would still be subject to the bankruptcy court's jurisdiction, a certificated strip is a separate asset that should have value in the same way any interest-only strip would have value in a securitization.
If the industry is committed to providing greater liquidity for servicers entering into the business, it must devise creative solutions to solve or mitigate some of the problems that drive lenders away from the asset. While no solution is bulletproof, reexamining these structures in the private-label securitization market can offer greater comfort to lenders who would otherwise be hesitant to enter.
Karen Gelernt is a partner in Alston & Bird's Finance Practice in New York.
