Ocwen Financial, the largest independent mortgage-loan servicer, has been buying up competitors, and investors in RMBS that pool loans that have been serviced by those competitors may see their interest on those bonds deferred for months, if not years.
Most recently, Ocwen teamed up with Walter Investment Management and beat out competitor Nationstar Mortgage in the bankruptcy-sponsored auction for Residential Capital’s (ResCap) mortgage servicing and origination platform. In early October, the Atlanta-headquartered company announced that it was buying Homeward Residential from WL Ross & Co., and other recent purchases have included mortgage servicing operations run by Morgan Stanley (Saxon Mortgage Services) and Goldman Sachs (Litton Loan Servicing).
Consolidation among independent servicers should enable Ocwen and other survivors — Lewisville, TX’s Nationstar has also been aggressively acquiring other servicers — to gain economies of scale and compete more effectively against the servicers owned by the nation’s biggest banks. However, investors in RMBS that buy mortgages previously serviced by one of the firms acquired, especially by Ocwen, may suddenly find their securities facing interest shortfalls.
The reason is Ocwen’s low servicer advance rate, in which it advances payments from delinquent loans to the securitization trust with the intent of recouping those payments later on, typically when properties are liquidated. Ocwen’s advance rate ranges from 26.2% to 13.6%, depending on the portfolio of mortgages, compared to Wells Fargo’s rate of 72.5% or higher, the highest in the industry, according to data compiled by Bank of America Merrill Lynch.
Nationstar’s rate, meanwhile, is in the middle of the pack at 46.2%.
ResCap has a 70% advance rate, which is very high, so it will be interesting to see what happens to those advances now that it’s going under the Ocwen umbrella,” said Brian Grow, RMBS managing director at Morningstar.
Grow said that a sample of 2600 RMBS showed that 54% had fewer advances than six months ago, while only 30% had more.
Those advance rates are critical to investors, especially in the subprime sector where delinquencies are more prevalent, since curtailing them could result in a shortage of cash in the trust to make interest and even principal payments. Ultimately, investors should recoup those losses when properties are eventually liquidated, but the present value of the cash from their investments is eroded.
Depending on how a particular RMBS is structured, some investors may be impacted more than others.
“The temporary impact to bondholders could be disruptive, and especially the subordinated bondholders, since their repayment of interest is often at the bottom of the [cash flow] waterfall after all the payments to senior bondholders,” Grow said. “So it may take longer for subordinated bondholders to get interest payments.”
Most RMBS documents require servicers to make advances of principal and interest until they deem them to be no longer recoverable, general language that results in widely ranging interpretations. In addition, most agreements allow servicers to withdraw advances from trust retroactively, which can result in unexpected cash shortfalls.
Servicer advance rates have declined over the past few years because of falling property values and much longer periods to liquidate properties — 32 months on average today and in some states as long as four years, compared to 10 months at the start of the housing crisis in 2007. That’s prompted many servicers to decide that advances increasingly aren’t recoverable.
“If there’s 7% interest on a loan, then the servicer would have to advance 7% for as long as four years, and that’s basically 28% of the principal balance of the loan,” said Chandrajit Bhattacharya, head of non-agency RMBS and consumer ABS strategy at Credit Suisse.
Credit Suisse sees consolidation as a major theme in the servicer space over the next few years, Bhattacharya said, adding that some services are far more “punitive” in terms of advances. “If there’s more industry consolidation, from servicers that advance more to those advancing less, then there’s going to be cash-flow issues on some deals.”
Jeremy Schneider, director within U.S. RMBS at Standard & Poor’s, said cash-flow issues resulting from trusts experiencing interest shortfalls can be exacerbated in several ways. For example, a new servicer may apply different loan modification strategies to a newly acquired loan pool, allowing it to recoup advances that had already been made by the pool’s previous servicer.
In a report published Oct. 8, S&P provides an example with Ocwen, which changed the loan modification policy on some of the transactions it acquired from HomEq Servicing Corp. and recouped advances that had already been made.
The reimbursements it took for certain transactions, however, absorbed the cash flow received for that period, resulting in interest shortfalls to all of the rated classes as well as missed payments to swap counterparties, triggering swap termination events. As a result, S&P lowered 32 ratings related to the affected transactions. “We believe the swap termination event and shortfalls to securities holders may not have occurred if the transaction included a plan for the servicer to communicate with transaction parties and/or rating agencies prior to implementing changes to servicing practices,” the report noted.
Currently, however, there are no standards for loan information that servicers provide to the securitization trusts and, in turn, what trusts pass on to investors. Consequently, investors often receive little if any information about what loans servicers are providing advances for.
The rating agencies and some analysts at major banks have developed models that use inputs from loans in RMBS pools to estimate servicers’ advance rates and project their paths. Servicer advances emerged in the first place to maintain steady cash flows into the trust. The process worked well when the mortgage market was growing and delinquencies were relatively rare, and so transparency was less of an issue.
Today, however, with some subprime pools experiencing delinquencies on upwards of half of their loans, understanding when servicers provide advances can provide critical information about how to price the securities.
“If the servicer continues to advance on a loan that’s not recoverable, ultimately it’s going to end up creating a worst default severity for that loan,” said Wyck Brown, president of BlackBox Logic, a provider of RMBS data. “So some investors think servicers are better to stop advances earlier and work out a liquidation so the severity on default is lower.”
Conversely, timely information about when a servicer stops advances can provide an important indication about the current status of the pooled loans and their respective properties. Servicers typically update little of that information after the loan is originated, so greater transparency into servicer advances could ultimately help investors gauge the health of the RMBS more accurately. Brown noted that the servicer may have received a broker price opinion that noted a house is in severe disrepair and decided to halt advances since recovering further advances is unlikely.
“That picture of the property doesn’t come through with the normal information investors have access to, Brown said, adding that information about servicer advances can act “as a sort of canary in the coal mine.”