Banks are losing their appetite for servicing the mortgages they underwrite. Although the two businesses once seemed complimentary, new capital requirements make it much less attractive for lenders to keep servicing rights on their books. Throw in the stringent requirements imposed by the National Mortgage Settlement, and servicing is suddenly much  a less attractive business.

There is no shortage of players willing to replace banks, but these relative newcomers don’t have the same access to cheap funding as depositary institutions. Servicers don’t just collect interest and principal payments and distribute them to holders of mortgage-backed securities; they also advance funds to investors when borrowers miss payments.These advances are eventually reimbursed, but it can take months, and in some cases years.

So what you have is a capital-intensive business — advancing payments — with a reliable stream of revenue: the perfect recipe for securitization.

Investors are taking a shine to this once-obscure asset class, and the structuring of deals is becoming more efficient. Already this year, issuance of securities backed by servicing advance receivables stands at $1.9 billion through March.

Joseph O’Doherty, managing director in the securitized products group at Barclays, expects issuance of servicing advance receivables-backed securities grow to $5 billion this year, surpassing the $3.17 billion issued in 2012, according to ASR figures.

There’s one caveat to this growth however: It is largely limited to new acquisitions of mortgage servicing portfolios. On a going-forward basis, most rated RMBS deals are likely to be prime deals, with fewer delinquencies and less of a need for regular advances.

“Over the next couple of years we expect new RMBS issuance to be predominantly prime securitizations. Compared to pre-crisis issuance, which included subprime and Alt-A collateral, issuance volumes will most likely be lower and of a higher credit quality; that should result in lower levels of advancing by servicers” said Sagar Kongettira, a senior vice president at Dominion Bond Rating Service (DBRS).

Banks, Deconsolidation and MSRs

In February 2012, 49 state attorneys general and the federal government announced the $25 billlion National Mortgage Settlement with the five largest U.S. mortgage servicers: Ally/GMAC, Bank of America, Citi, JP Morgan Chase and Wells Fargo.  The agreement resolves allegations that servicers forged documents used to process foreclosures.

The stringent new servicing standards imposed by the settlement, not to mention the financial penalites, have contributed to the sell-off of mortgage servicing rights by banks.
New capital ratio guidelines proposed under Basel III are also making mortgage servicing less attractive for banks. 

Another factor driving deconsolidation is the fact that banks weren’t really set up for servicing non-performing mortgages. As delinquencies in residential mortgages rose, banks have been looking to get rid of the operational risk of servicing large portfolios of delinquent mortgages.  

“You have significantly more advance-related collateral available that needs financing because now you have homeowners that are just trying to make ends meet and may not be able to make their monthly mortgage payments and are having problems keeping up with their property taxes and insurance in escrow—that creates a growing advancing obligation on behalf of the servicer that needs to be met,” said Rudene Haynes, a partner at Hunton & Williams LLP.

Thomas Hiner, a partner in the same law firm, said that there are numerous companies that are getting into the business and are acquiring servicing from banks. “There are still a lot of acquisitions happening on the private-label side and there will continue to be a need for advance financing to support these acquisitions and the ongoing servicing performance post-acquisition,” he said.

U.S. banks are expected to unload up to $2 trillion in mortgage servicing rights, according to the American Banker. Among the big banks, only Wells and U.S. Bank are expanding their portfolios, while the others are shrinking them. Wells reported $1. 9 trillion in servicing assets as of the third quarter of 2012, accounting for approximately 19% of the total market.  Meanwhile, U.S. Bank grew its portfolio by 2.3% on a quarterly basis and 14.6% on a yearly basis.   But in March, chief financial officer Timothy Sloan told investors that the bank may “test that market” for selling servicing rights in a bid to reduce the size of its portfolio.  

Ocwen and Nationstar, two of the biggest players in the non-bank servicing space, have snapped up mortgage servicing rights on loans that came up for bid over the past 15 months.  
Most recently, in February Ocwen completed the acquisition of certain assets of Residential Capital LLC; the portfolio includes the unpaid principal balance of $107.3 billion of mortgage servicing rights on private-label, Freddie Mac and Ginnie Mae loans; $42.1 billion of master servicing agreements, and $25.9 billion of subservicing contracts.

To finance the ResCap acquisition, Ocwen said it raised approximately $840 million of net additional capital in the term loan market.

Also in February, JPMorgan said it would sell a chunk of its mortgage servicing operation to Wingspan Portfolio Advisors, a Dallas company that specializes in servicing distressed debt.  Jim Hennessy, managing director at Strategic Vantage, which represents Wingspan, said that the mortgage servicer has not issued term ABS to date and has not announced plans to issue anything in the near future.

Nationstar, which is majority-owned by Fortress Investment Group LLC, said in on its March 8 earnings report that it increased its servicing portfolio by 94% last year to $198 billion through a series of asset purchases.  The company’s portfolio rose to more than $300 billion last month after the completion of part of a deal for $215 billion of contracts from Bank of America.

Ocwen, Nationstar Increase Term ABS

Ocwen set up a separate company, Home Loan Servicing Solutions (HLSS), that in turn created a master trust for private-label servicing, completing its first securitization in October 2012.  The master trust issued $250 million one-year and $450 million three-year term notes secured by servicing advance receivables.

HLSS has since come to market three times.  In January it issued three tranches  of notes secured by servicing advance receivables at a weighted average interest spread over LIBOR of 0.94%. Proceeds from the $650 million of one-year, $350 million of three-year and $150 million of five-year term notes were used to reduce borrowings on variable funding notes. 

In a press release, HLSS President John Van Vlack said strong executions in the ABS term note market continues to reduce borrowing costs beyond the firm’s expectations.

Also in January, Nationstar priced $300 million in asset-backed term notes, in what it said was the first-ever agency servicer advance securitization. Nationstar’s chief exeutive Jay Bray described the securitization as a way to further diversify the firm’s funding sources, reduce advance funding costs and establish “a precedent” for financing its advances with fixed-rate-term debt at a very opportune time in the rate cycle.

The securitization helped reduce the LIBOR-based rate of the notes from 1.65% (as of January 24, 2013) to a weighted average fixed interest rate of 1.46% and a weighted average term of three years. These notes replace $300 million in existing agency servicing advance facilities that carried a weighted average floating rate of Libor plus 2.86%, or 3.1% in total, Nationstar said.

“We intend to access the ABS markets frequently as we execute on our stated goal to lower advance expenses to drive further gains in servicing profitability,” said Bray in a press release. As of Sept. 30, 2012, Nationstar serviced over one million residential mortgages with a servicing portfolio totaling $198 billion in unpaid principal balance. 

The servicer said its programmatic term ABS issuance program allows it to efficiently finance current and future acquisitions of agency and non-agency servicing advance assets.
Hiner said that in 2012, Hunton & Williams handled more than 20 financings of servicing advances, including securitizations, for a total in excess of $10 billion.   

The advances that are typically securitized fall into three categories: principal and interest (P&I) advances, which cover delinquent scheduled mortgage payments; escrow advances, which cover unpaid insurance and taxes; and corporate advances, which cover costs related to property maintenance and liquidation. 

Standard & Poor’s, which has rated both the Nationstar and HLSS deals, said that in the last couple of transactions,  the servicers securitized not just their advance receivables, but also the servicing fees. In the past they had not securitized these fees or had lumped them into the P&I structure.

Better Execution Onshore

Today, the trusts issue both revolving notes and term ABS.  The term ABS classes have fixed principal balances for a defined period of time, at the end of which these ABS are either refinanced with new bonds, or begin to amortize, typically according to a pre-set amortization schedule.

Hiner explained that a servicer advance receivable converts to cash when it is reimbursed out of cash flows in the underlying mortgage loan pool, similar to trade receivables. 

“For these bigger players, the master trust structure is a preferred avenue because it brings to the table more deal efficiency; it works with the needs of the servicer and it likewise caters to the needs of the market, in terms of how investors want to acquire the bonds, explained Haynes.

The most recent versions of the master trust structure have eliminated many of the complexities that had made some of the earlier offshore master trust structures cumbersome.  Hiner said that the newest structures seem to have “more or less, “settled into a balance of the interests and needs of servicers, investors, and bank lenders alike, at least for the time being.”

O’Doherty said that the initial master trust servicing advance deals Barclays did in 2004 were executed as offshore vehicles to avoid “taxable mortgage pool” issues.

Post 2008, some lenders began doing onshore deals, but these deals were structured as “owner-trust” structures, not the master-trusts seen in the more recent Ocwen and Nationstar deals. “The problem with an owner-trust structure is that it didn’t give issuers the flexibility to issue multiple maturities,” said O’Doherty.  

By January 2012, the structure, via the Barclays-led deal for American Home evolved to a combination onshore/offshore structure. And in October 2012 Barclays arranged a completely onshore master trust for the HLSS that has since come to market with multiple term issuances.
Both Nationstar and Ocwen, in their latest deals, have issued five-year bonds in addition to the one-year and three-year seen in past deals. The demand for these maturities, said O’Doherty, is “substantial.”

“When you have a master trust structure you have all of the underlying collateral supporting the cashflows and payments on securities that might be issued from time to time,” said Haynes. “It also makes it easier for an issuer to execute additional issuances in the future, once a master trust is set up.”

Evolution of Asset Class

Hiner said that servicer advance financings in the past closely resembled secured corporate loans with bankruptcy-remote structuring.  In these relatively straightforward structures, the servicer’s financing entity issues secured revolving notes that can be drawn-up as cash is needed, to fund advance outlays and are paid down in the course of a month as the advances are reimbursed. 
Many of these deals do not include term asset-backed securities notes and have no offering document, but instead were negotiated like a bank loan between lender and borrower. 

Issuers of servicing advance receivables securitizations can thank the Term Asset-Backed Securities Loan Facility, introduced by the Federal Reserve in 2008, for making it easier to get the better cost funding available today. On March 19, 2009, the Fed expanded the list of collateral eligible for pledge under its TALF program to include servicing advance receivables.  Despite the fact that the program was short lived, “TALF gave servicers the ability to get cheaper financing to provide liquidity for their advancing obligations, and when the program ended, there were a lot more investors that were accustomed with the product and were more willing to invest in it,” said Haynes.

O’Doherty said that in the initial servicing advance deals that Barclays did in 2004, the bank talked to 25 investors; but with each subsequent deal, the bank has picked up more investors. “It’s got to the point that there are so many investors that know and love this asset class, that for [the] Nationstar and HLSS deals, before the deals are announced, all of their subordinate bonds are well oversubscribed,” he said.

Driving this appetite is the fact that investors now understand the dynamics of the asset class. Servicers have a super-senior right to reimbursement off of all cashflows into the trust because the servicer in the underlying mortgage deal is obligated to make out of pocket payments that are meant to serve as a source of liquidity, not a source of credit support. 

“The asset itself is super-senior, but saying that was a problem at one point,” said O’Doherty.  “Investors now understand that, unlike other super senior interests in highly leveraged deals, in servicing advances it’s a super senior interest in the underlying mortgages,” said O’Doherty.
Another attraction for investors is the fact that both Nationstar and HLSS are becoming more programmatic issuers in the asset class.

New Servicer, New Routine

Tranching in recent deals may indicate that the parties involved are showing increased comfort in participating in the space; it also highlights the fact that, when a servicer portfolio moves from one entity to another, it brings with it the risk that the new entity may service the loans a bit differently to the old one.

“To the extent that things change, such as borrower behavior or servicer behavior for that matter, could have a meaningful impact on how much proceed comes across, into the transaction and; how the various stress analysis that is applied to that cash flow ultimately impacts that security,” said Roelof Slump, a managing director at Fitch Ratings.

Some variances could come from how aggressive the servicer is with regard to loan modifications or short sales, which would have a “material” impact in terms of when the trust gets reimbursed from those advances. “It could be a positive thing for these transactions but as new laws come about and as timelines get stretched it could work the other way as well,” said Slump.

JP Morgan published a on Feb. 22 highlighting some of difference between servicers. Ocwen, for example, is a predominantly subprime servicer and its statistics around modifications and advancing suggest that it has been more aggressive with modifications and has a lower advancing rate.  The credit score of an Ocwen loan is closer to 630. In contrast, the average credit score for Bank of America and Chase loans are close to 700.

Another noteworthy difference is the proportion of California loans, which represents close to 40% of Bank of America loans and only about 20% of Ocwen loans.  “In some jurisdictions, Ocwen or any other servicer buying servicing rights may not find it as easy to foreclose as they may have done in the past,” JP Morgan analysts said in the report.

Better Underwriting Means Less Servicing

The one caveat to growth for the asset class is a big one. 

Once banks have finished shedding their mortgage servicing portfolios,  securitizationss will largely be driven by refinancings of older debt and issuance is likely to become more programmatic and less explosive. 

Kongettira at DBRS notes that the revival of the private-lable RMBS market is likely to create much of a need to fund servicing advances. That’s because most  rated, private-label RMBS deals are likely to be backed by prime loans, resulting in fewer delinquencies and therefore less of a need for regular advancing.

Servicing advances on agency mortgages have historically been difficult to securitize because the source of repayment for some of the advances is the agency itself (not just the closed-end pool of securitized mortgage loans).  A transaction you could potentially have certain reimbursements or advances that are non-recoverable by the servicers because they are “set-off” by some other claim.

As a result, agency advances have historically been financed either by the related GSE, or through more traditional leveraged loans secured by all unencumbered assets of the servicer. 
Hiner said that investors have been unwilling to finance agency advances absent a confirmation from the related agency that it would not set-off claims against the seller/servicer against these reimbursements.

“Agency advance securitizations would see a lot of growth if the GSEs could give set-off waivers for the advance reimbursements,” he said. “This would make the agency servicer advancing function more efficient for the agency servicers.”

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