US Mortgage Servicers – Key Considerations for Distressed Mortgage M&A Transactions

Any company in a distressed scenario faces challenges, but this is especially true in the mortgage industry as residential mortgage loan servicers grapple with competing regulatory, licensing and bankruptcy law considerations.  As forbearance requests rise as a result of the COVID-19 pandemic, so do liquidity challenges for residential mortgage loan servicers.

Servicers of mortgage loans are particularly susceptible to liquidity challenges because they are typically required to continue to make servicer advance payments, notwithstanding the requirement to provide forbearance for borrowers subject to a COVID-19 hardship.  This naturally creates significant cash flow challenges because this requirement is likely coupled with the diminishing ability to borrow against these advances as a result of rising delinquencies and forbearances.  Moreover, mortgage loan collateral securing credit facilities may be declining in value and making margin calls a greater issue. 

Mortgage trade associations have requested a government-backed credit facility that would provide mortgage servicers with much needed liquidity.  However, despite these lobbying efforts, according to Treasury Secretary Steven Mnuchin, the federal government currently has no plans to create a dedicated Federal Reserve facility to provide funding for nonbank mortgage servicers.  Industry participants believe that the likely rise of borrower forbearances will lead to unsustainable pressure on these servicers and particularly on nonbank servicers.  (Please see “The Case for Supporting Nonbank Mortgage Servicers” (Jon Van Gorp), April 8, 2020, and “Mortgage Servicers Are Getting the Short End of the Stick Under the CARES Act” (Laurence Platt), June 5, 2020.)

Fannie Mae and Freddie Mac (the “GSEs”) and Ginnie Mae have provided some partial assistance, including by implementing the PTAP/C19 loan facility (in the case of Ginnie Mae) and clarifying the advancing requirements on forborne loans (in the case of Fannie Mae and Freddie Mac).  In addition, the FHFA announced recently it would limit servicing advance obligations to four-months’ of forborne payments in Fannie Mae and Freddie Mac deals. While none of these programs offer a “silver bullet” to address all servicing liquidity issues, they are expected to help mitigate the capital outlay that otherwise might be required in these troubling times. 

Given the challenges that mortgage servicers are facing in the current climate, market participants may be interested in pursuing distressed transaction opportunities—in particular, through Section 363 asset sales.  Potential buyers should consider the following with respect to Section 363 asset sales in the mortgage context.

General Structure of a 363 Transaction

Section 363 transactions (named for the relevant part of Chapter 11 of the Bankruptcy Code) are sales of assets outside the debtor’s (i.e., the seller’s) ordinary course of business that are conducted as part of an in-court bankruptcy proceeding.  Because Section 363 transactions are done within the confines of federal bankruptcy laws, these transactions have many unique features that a buyer should consider. 

In Section 363 transactions, assets are typically sold “free and clear” of liens, claims, encumbrances and other liabilities, generally offering a buyer the opportunity to acquire assets with clean title (supported by a bankruptcy court order).  This will expressly include any security interests and liens by any lenders on the purchased assets, the holders of any such liens being compelled to look solely to the proceeds of the sale for any satisfaction of their claims.  In addition, buyers may have the ability to “cherry pick” assets, including, for example, with respect to mortgage servicing rights, and will typically have greater flexibility in not acquiring contracts that are burdensome or not economically attractive. 

These features can provide many benefits to buyers.  Buyers should note, however, that because buyers take the assets free and clear, sellers will usually take the position that the assets are being sold “as is” and will provide limited representations and warranties that do not survive the closing or that, as a practical matter, do not otherwise have a real or significant source of payment supporting them.  Buyers, therefore, often have limited post-closing recourse against sellers with respect to any unanticipated liabilities related to the assets.  In addition, there are several unique procedural challenges that a putative buyer should consider in any Section 363 transaction, including as a result of the open sale process subject to delineated sale procedures that usually occurs.  (Please see the following Mayer Brown materials for a more in-depth look at the 363 process: Primer on Distressed M&A: 363 Asset Sales (Nina Flax, Louis S. Chiappetta), Spring 2020, and “363 Preparedness: Practical Buy-Side Tips” (Louis S. Chiappetta, Nina L. Flax, Thomas S. Kiriakos and Sean T. Scott), April 16, 2020.)

In addition to the unique challenges presented by COVID-19, transactions involving mortgage originators and servicers, including 363 transactions, typically present the following issues and should be considered by potential buyers.

Mortgage Loan Warehouse Financing

Since the last financial crisis, non-bank financial companies have grown in market share of origination volume and holders of mortgage loans as compared to depository institutions.  To finance these originations and acquisitions prior to such nonbank’s execution of its take-out strategy, these nonbanking entities must look to depository institutions to finance the mortgage loans.  Typically, the financing takes the form of a repurchase agreement, whereby the nonbank entity transfers the mortgage loan to a banking institution in exchange for cash with an obligation to repurchase the mortgage loan at a date certain. While these arrangements are accounted for as loans for tax and accounting purposes, they are treated as sales for commercial law purposes and, so long as the agreements meet the definition of a “repurchase agreement” under the Bankruptcy Code, they are afforded protected contract status under the Bankruptcy Code.  This means that, among other protections, the buyer of such mortgage loans pursuant to a repurchase agreement would not be subject to the automatic stay if the seller were to become insolvent.

A key feature in many of these repurchase agreements is daily mark-to-market valuations of the mortgage loans by the banks and the ability of such banks to issue margin calls if the value drops below the purchase price.  If there is a market-wide disruption event, such as the market shock resulting from the COVID-19 pandemic, this market event may depress the value of mortgage loans on the books of lenders.  Nonbank entities are then forced to come out of pocket within one to two business days to satisfy these margin calls across a large portfolio of assets.  Margin calls across an entire portfolio of assets can create a huge liquidity crunch for these nonbank entities which, if not met, can create facility-level defaults which have the potential to bankrupt the non-bank entity.  As a result of the liquidity crunch resulting from the COVID-19 pandemic and resulting margin calls, many nonbank entities are looking to restructure these warehouse lines to be non-mark-to-market but, as one might expect, the cost for warehouse facilities without mark-to-market pricing is relatively high.             

Mortgage Servicing Rights

Buyers considering a transaction involving the purchase and financing of mortgage servicing rights (“MSRs”) should appreciate the complexity and volatility of this type of asset, especially in a distressed scenario.  MSRs are contractually created rights to service mortgage loans that can be owned and accounted for separately from the mortgage loans themselves.  The GSEs and Ginnie Mae, as counterparties to applicable servicing agreements, generally have the right to transfer servicing from a debtor to a more capable servicing platform if such party believes that the debtor is not capable of satisfying its obligations as servicer under the servicing agreement.   

For Ginnie Mae transactions, this is the case even after the servicer becomes a bankruptcy debtor. Notwithstanding general Bankruptcy Code provisions that impose an automatic stay against taking action to terminate a servicing agreement, that render any bankruptcy/financial condition termination events ineffective, and that permit a debtor to assume or assume and assign an advantageous servicing agreement, there is a federal statute, 12 U.S.C. § 1721(g)(1), that expressly overrides those provisions in favor of Ginnie Mae.  Specifically, this statute expressly authorizes Ginnie Mae to immediately terminate and move servicing in such a situation if it so chooses.  While there is no such federal statute in favor of Fannie Mae and Freddie Mac, as a practical matter, each GSE nonetheless is likely to have a significant voice regarding the continued servicing of mortgage loans owned by them, including after the commencement of a servicer bankruptcy, particularly where the proposed buyer is not already approved as a servicer by such GSE.  As a result, a buyer must be prepared to have an open dialogue with the applicable GSE and be in a position to readily take over servicing as part of its acquisition of the MSRs. 

In addition, the value of an MSR is based on the servicing revenue less expenses related to such loan and adjusted for estimated prepayment speeds and delinquency rates.  Because MSR assets are highly correlated to interest rates and default rates, the value can be quite volatile.  The volatility of the MSR valuation and the rights of the owner of the loan vis-à-vis the owner of the MSR present complexities when trying to finance the asset.  The key to detangling these complexities is understanding any rights and requirements the owner of the actual mortgage loan may have in connection with financing of the related MSR.  

For loans owned by private entities and trusts (as for agency loans), the contract that created the servicing right will also detail servicing obligations and servicing fees of the MSR owner, which are factors in the MSR valuation.  Because these private entity contracts are bespoke, it can be a complex undertaking to provide a valuation of the MSR.  In addition, many of these agreements will prohibit a transfer of the MSR without the consent of the mortgage loan owner and satisfaction of certain other conditions.  While this consent usually can be overridden in a bankruptcy of the servicer under general Bankruptcy Code provisions that vitiate such anti-assignment clauses, the debtor servicer would nonetheless still have to satisfy the Bankruptcy Code requirements for the assumption or the assumption and assignment of the servicing agreement, which are discussed in greater detail below.  For a party lending against MSRs, this consent right of the mortgage loan owner to a transfer of the MSR can create a significant hurdle to foreclosing on the MSR if there is a default under the underlying credit agreement. 

With respect to loans owned by Freddie Mac, Fannie Mae or Ginnie Mae or that comprise part of a Freddie Mac, Fannie Mae or Ginnie Mae bond, the MSR-secured creditor and the servicer are required to execute an acknowledgement agreement with the related agency, whereby such creditor will acknowledge that such agency has specific rights vis-à-vis the mortgage loans and MSR financing facility.  While the acknowledgement agreements for each agency contain nuanced and disparate requirements and rights, as a general matter, under each of these acknowledgment agreements the secured creditor agrees to adhere to certain procedures following a default under its agreement and agrees to limitations regarding its rights to transfer servicing following such a default. 

In addition, under each acknowledgement agreement, the MSR-secured creditor agrees that following a default under an agency agreement, the applicable agency can extinguish the secured creditor’s rights to the related MSRs unless, in the case of Fannie Mae and Freddie Mac, such creditor (or some other party acceptable to such agency) assumes the servicing obligations and puts in place a new servicer or, in the sole case of a payment default under a Ginnie Mae agreement, the secured creditor cures such default within one business day.  Finally, the secured party under each acknowledgement agreement agrees to fairly broad indemnity obligations with respect to the related agency. Because of the volatility of the MSR valuation and the agency rights that greatly limit creditor’s rights, the advance rates for credits secured by MSRs tend to have higher haircuts and can be somewhat challenging to finance.  

Servicing Advances

Similar to MSRs, to understand the issues that arise with servicing advances, buyers should first understand the interests of the mortgage loan holder/investor.  Are the loans held in a private label securitization or are they part of a Fannie Mae, Freddie Mac or Ginnie Mae security? 

With respect to loans held in private label securitizations or by other private entities, the devil is in the details.  Each individual servicing agreement (which may be in the form of a pooling and servicing agreement or servicing agreement as modified by an assignment and assumption agreement) will detail whether servicers must make advances related to principal, interest, taxes, insurance or corporate advances, or some combination of these.  Each of these documents will also specify in more or less detail the parameters surrounding when a servicer can seek reimbursement and the servicer’s ability to obtain financing for the capital outlay related to the advance receivables.  Having a basic sense of what specific advancing obligations exist and how quickly those advances can be reimbursed will help to provide metrics for the capital outlay needed to fulfil these obligations.

For loans held by trusts related to agency bonds, the risks can be more easily quantified because each agency has its own uniform set of rules and guidelines.  In Fannie Mae and Freddie Mac-related securitizations, Fannie Mae obligates servicers to fund principal and interest (“P&I”) advances until the loan is re-characterized as delinquent and more generally to fund taxes and insurance (“T&I”) and corporate advances.  For Freddie Mac, principal payments do not need to be advanced but all other forms of advancing are required.  Reimbursements for these advances will come from Fannie Mae or Freddie Mac, respectively, although the timeframes for these reimbursements will vary by agency and advance type.  For loans held by trusts in Ginnie Mae-insured securitizations, P&I, T&I and corporate advances need to be advanced until the loan is bought out of the securitization.  Reimbursements for these advances primarily comes from insurance claims proceeds or liquidation proceeds, not from Ginnie Mae, and the timing for the remittance of those proceeds similarly varies based on advance type and source of repayment. 

In addition to understanding the advancing obligations and reimbursement rights and related timing therefor, what entity holds the loans will also dictate the ease of financing these obligations because private holders and each of the agencies have different restrictions on a servicer’s ability to finance the capital outlay required for these advancing obligations.

Again, for loans held in private label securitizations or by other private entities, while it is generally permissible to finance these receivables, each underlying servicing agreement will be unique and needs to be diligenced to understand the scope of these rights.  

For Fannie and Freddie Mac-related loans, the servicer and related creditor providing the financing of the advance receivables must obtain consent through either a consent agreement (with respect to Freddie Mac) or an acknowledgement agreement (with respect to Fannie Mae).  Furthermore, Fannie Mae and Freddie Mac will recognize the rights to advance receivables as severable from the MSR and the rights of servicers to be reimbursed for those advances.  They also will recognize the rights of secured parties to those advance receivables.  

While Ginnie Mae will also require a secured creditor to execute an acknowledgement agreement, Ginnie Mae otherwise treats advances differently than the other two agencies.  Until recently, Ginnie Mae would not recognize the advance receivable as distinct from the MSR.  While Ginnie Mae will now recognize the advance receivable, Ginnie Mae will not recognize the rights of more than one secured party to the MSR and advance receivable on an aggregate level.  In order to efficiently and more broadly finance these assets, a complex securitization structure is required pursuant to which the owner of the aggregated MSRs (which includes the advance receivables) issues participation certificates representing the beneficial interest in certain components of its MSRs (including the advance receivable income stream).  Ginnie Mae also will not recognize a secured party’s right to the receivables post-termination of the servicer.  If Ginnie Mae terminates the servicer, unless the cause for termination is due to a payment default that the secured party cures within one business day, the security interest of the secured party is terminated.  Practically speaking, this means that any capital lent against Ginnie Mae servicing advances (or the MSR more generally), while technically recoverable from several sources other than the servicer, is inextricably linked to the performance and creditworthiness of the servicer.

The distinction in treatment between Fannie Mae and Freddie Mac advance receivables, on the one hand, and Ginnie Mae advance receivables, on the other hand, results in advance receivables related to Fannie Mae and Freddie Mac loans being simpler to finance and typically on better terms than Ginnie Mae receivables because more creditors are willing and able to finance Fannie and Freddie advance receivables.  

Licensing

Asset sales in the mortgage space typically involve acquisitions of branch offices operated by seller, including transfers of mortgage loan officers and branch managers and pipeline loan assets.  When a buyer considers a branch office acquisition, one of the first diligence questions should be whether buyer has the requisite entity-level state licensing approvals to operate the branch offices consistent with buyer’s business plan.  For instance, if seller originates loans under the California Residential Mortgage Lending Act (“RMLA”),  buyer should consider whether a RMLA license would be necessary or advisable to allow buyer to operate the branch offices going forward.  If buyer needs to obtain new entity level licenses, the license application process could delay closing.  In the alternative, buyer may opt not to originate loans post-closing in certain states while the related license applications are pending, but decreased origination volume could have an adverse  effect on revenue, not to mention an increased risk of losing high-producing mortgage loan originators (“MLOs”) if they are unable to originate as expected in the impacted states.

State regulatory authorities also license specific branch offices. In a branch office acquisition, seller and buyer will seek consent from the state licensing authorities to transfer authority to buyer at closing.  Seller and buyer should also consider whether notice to any federal agencies or investors may be required.  Note that Fannie Mae, Freddie Mac and Ginnie Mae require 30–75 days’ notice of branch office acquisitions. These state and federal agency approvals and notice requirements should be considered for purposes of identifying a target closing date. Depending upon the underlying circumstances, federal and state agencies may be prepared to accommodate a shorter notice period.  Regardless, any putative buyer should be prepared to be proactive in engaging with these agencies. 

If substantially all employees will transition to buyer at closing, a transition services agreement may be necessary to assist seller in closing down the remaining loan pipeline after closing, but note that certain employees must remain with seller until the pipeline is fully closed in accordance with certain agency licensing requirements.  In order to transfer the loan pipeline to buyer at closing, the parties must consider notice filings to HUD, VA and USDA to transfer loans in process, authorized personnel, and principal/agent relationships.   

Rebranding and changes to dba names pose another challenge for branch office acquisitions. Buyer will be required to register the various dba names under which the branch offices operate with each state secretary of state office.  However, secretary of state offices may not approve the name for use by buyer until the name has been surrendered by seller.  This creates a tricky transition period at closing and may lead to a temporary hold on loan originations if dba names are not surrender/transferred on a timely basis.

Closing may be especially tricky during the annual “renewal” period in November and December of each calendar year. Many states focus strictly on renewals during the fourth quarter and there tend to be competing acquisition transactions stacked in the queue approaching the holidays.  Planning ahead and good communications with the regulators may help facilitate closings during this more challenging time. 

Treatment of Servicing Agreements in Bankruptcy

Buyers considering acquiring the assets of a mortgage originator or servicer through the 363 process should be aware that seller’s servicing agreements would likely be treated as executory contracts within the meaning of Section 365 of the Bankruptcy Code.  Buyers will need to identify which servicing agreements are profitable and should be included in the purchased assets and which are not profitable and thus should be excluded from the purchase.  For those to be included, the Bankruptcy Code provisions governing the assumption and assignment of executory contracts, including the requirements that monetary defaults be cured and the assignor provides "adequate assurances" of its ability to perform going forward, would have to be satisfied.  This may be a challenge for private equity and hedge fund buyers that do not yet have a servicing platform.  Also, how these assumption/assignment costs will be allocated in a transaction—will they be borne by the bankrupt seller or by buyer in addition to the stated purchase price?—will be a subject of negotiation in a transaction.  Buyers should also be aware that the general rule is that an assignee is bound by the provisions of the assumed servicing agreement as it is written and, absent the consent of (or the lack of an affirmative objection by) the counterparty to the servicing agreement, buyers cannot impose modifications to those provisions. 

Representations and Warranties Insurance

With the likely rise of distressed transactions, Section 363 asset sales, including those involving a mortgage business, may provide opportunities for risk allocation to a transactional liability insurer through a representations and warranties insurance policy.  As mentioned above, Section 363 transactions typically allow buyer to acquire assets “free and clear” of liabilities.  However, depending on the type of liability and/or the jurisdiction, there may be certain liabilities subject to which buyer may nonetheless be required to take the purchased assets.  For example, Section 363(o) of the Bankruptcy Code provides that, "if a person purchases any interest in a consumer credit transaction that is subject to the Truth-in-Lending Act or any interest in a consumer credit contract (as defined in section 433.1 of Title 16 of the Code of Federal Regulations (January 1, 2004), as amended from time to time), and if such interest is purchased through a sale under this section, then such person shall remain subject to all claims and defenses that are related to such consumer credit transaction or such consumer credit contract, to the same extent as such person would be subject to such claims and defenses of the consumer had such interest been purchased not" in a Section 363 sale. 

Depending on the jurisdiction, these liabilities also may involve product liability, regulatory compliance, environmental and intellectual property risks. If there are adequate representations and warranties in the purchase agreement covering these potential risks, then coverage could be available under a representations and warranties insurance policy. (For a more in-depth discussion on transactional liability insurance in distressed and mortgage M&A, please see the following recent Mayer Brown Legal Updates: “Transactional Liability Insurance in Distressed M&A: Challenges and Opportunities in Using Representations and Warranties Insurance in Section 363 Transactions” (Joseph A. Castelluccio, William R. Kucera and Sean T. Scott), April 28, 2020, and “Representations and Warranties Insurance in Mortgage M&A – Challenges and Opportunities” (Lauren Pryor, William Kucera, Libby Raymond and Michael Serafini), April 28, 2020.)

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