Representations and Warranties Insurance in Mortgage M&A – Challenges and Opportunities

The use of representations and warranties insurance policies in M&A transactions has grown exponentially in the past decade. While the use of this type of insurance in acquisitions of residential mortgage originators and servicers is less common, there is tremendous opportunity for growth in the mortgage sector.

Benefits of R&W Policies

Representations and warranties insurance policies typically provide insurance coverage that either supports or replaces indemnification for breaches of certain representations and warranties made by the seller in a purchase and sale agreement. Benefits of representations and warranties policies include the following (considerations that are particularly important in distressed sales):

• Facilitating discussion and leading to less contentious negotiation because many potential post-closing indemnity claims will be subject to insurance coverage. Moreover, buyers will have comfort that claims will be made to a creditworthy entity.
• Allowing for longer survival periods than what the seller may be willing to provide alone.
• Involving transactions with smaller indemnity escrows, allowing sellers to keep a greater portion of cash consideration at closing.
• Supporting a productive relationship between buyer and seller post-closing. In mortgage deals, it is common for individual owner/operator sellers to become key employees of the buyer post-closing in order to drive the newly acquired business. Both sides benefit in their continuing business relationship if indemnity claims are made against an insurer rather than by the buyer against the seller.

Coverage and Key Exclusions for Mortgage M&A

Representations and warranties policies generally cover breaches of basic corporate representations and representations and warranties related to the historical operations of the target company, including, for example, financial statements; intellectual property; material contracts; and environmental, labor and employment, employee benefits and tax matters. Representations and warranties policies typically exclude special indemnity items, covenant breaches and breaches that are known to the buyer.

Although general compliance with laws and licensing representations may be covered, mortgage regulatory compliance representations and mortgage loan-level representations are generally excluded from representations and warranties policies, including representations addressing the accuracy of the loan tape data and portfolio valuations as well as the adequacy of loan loss reserves and loan collectability. Some buyers in mortgage deals may nevertheless elect to proceed with representations and warranties insurance because it provides additional comfort with respect to non-mortgage representations.

Historically, insurance carriers faced challenges in effectively underwriting mortgage-specific representations and warranties. These challenges stem from perceptions of legacy loan repurchase and indemnity risks arising from less robust compliance systems and credit underwriting standards in place prior to the financial crisis in 2008. Loan repurchase demands, in particular, offer a unique challenge as a remedy in the mortgage space. Arguably, these risks could be assessed during the due diligence process and should be somewhat mitigated by broad state and federal regulatory requirements imposed since the financial crisis and enhanced credit underwriting standards now applicable to residential mortgage loans.

Comprehensive representations and warranties insurance coverage for regulatory compliance matters and loan portfolios would be a “game-changer” in mortgage M&A because losses arising from regulatory compliance breaches and whole loan or servicing rights portfolios tend to pose the most material risk for mortgage company buyers. If representations and warranties policies covered these risks, the question of known breaches would warrant special consideration. Buyers should take a close look at the definition of “knowledge” in the policy. As an example, a buyer acquiring a mortgage servicer may carefully consider whether knowledge obtained by a third party performing mortgage loan due diligence would be imputed to the buyer and whether information gleaned through a review of thousands of pages of data tapes would similarly constitute “knowledge” of a breach of the applicable representations or warranties.

Opportunities in Mortgage M&A Deals

There may be opportunities for representations and warranties insurance carriers in mortgage M&A deals if the most material risks could be effectively underwritten. To that end, what would it take for mortgage-related representations to be covered consistently? The following key factors may be considered:

• Regulatory Compliance Expertise in Insurance Underwriting. Insurance underwriters may require specific expertise (either from outside counsel or internally) to review mortgage regulatory compliance functions of originators and servicers, including the applicable compliance management systems, vendor management, privacy matters and origination and servicing practices and functions.
• Effective and Quick Loan-Level Diligence. Insurers may require that the buyer engage vendors that can perform meaningful loan sampling due diligence within timeframes necessary to accommodate deal speeds and in volumes that provide the buyer and the insurer with comfort that the sample size is representative of the portfolio as a whole.
• Special Retention Amount. Insurers may require a special retention amount that would function as a deductible specific for compliance or loan-level claims. Insurers are not likely to take losses that are generally considered to be the “cost of doing business” in the mortgage space. A certain degree of loan-level indemnification and repurchase claims is inherent in mortgage origination and servicing. Look-back periods on legacy claims may be another mitigating factor to consider in drafting the related representations and warranties. Diligence of loan loss reserve amounts and covenants by the buyer to maintain expected levels could also mitigate the need for an additional special retention amount.
• Exclusions for Credit Losses. Policies may specifically exclude credit losses tied to performance of mortgage loan or servicing rights portfolios. We could also foresee specific exclusions related to losses tied to mortgagor forbearance as required by government regulations in respect of COVID-19 hardship events.
• Premiums, Retentions and Survival Periods. Comprehensive coverage for mortgage-related representations and warranties may require premiums and retentions on the higher end of the spectrum, as well as special survival periods for claims based on loan-level representations and warranties. We would expect these special survival periods to generally align with market terms in applicable loan purchase and sale agreements.

We predict that the mortgage M&A transactions that are most likely to be candidates for comprehensive representations and warranties insurance coverage are those involving target mortgage companies with robust compliance functions, minimal repurchase and litigation histories, no material regulatory enforcement actions, minimal balance sheet risk and a positive reputation in the market. A number of these factors may be evaluated during the due diligence process, including a review of the target company’s repurchase log and material whole loan and servicing rights purchase and sale agreements. We would expect to see immediate demand in mortgage M&A for representations and warranties insurance policies if regulatory compliance and loan-level representations could be covered on a comprehensive basis, even if these policies require higher premiums and retention amounts.