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Sub-servicing: an emerging niche.

SUB-SERVICING An emerging niche

On May 12, 1989, Memphis-based National Mortage Company closed a deal to sub-service nearly 60,000 residential mortage loans and the related GNMA securities. The contract was signed with Franklin Savings Association, an $11 billion savings and loan based in Ottawa, Kansas, just after the thrift had acquired the servicing.

The outstanding balances on the mortages involved in the subservicing transaction totaled approximately $3.4 billion. As a first-hand participant in the deal, I believe this kind of subservicing arrangement warrants a closer look by others seeking to grow servicing increase.

With billions of mortage servicing expected to come on the market from RTC liquidations alone, the price for servicing is likely to be depressed unless new, untraditional servicing investors can be brought in to the market. Subservicing is the perfect vehicle for encouraging investments by those lacking the expansive servicing infrastructure to absorb such assets. Furthermore, subservicing is a timely trend that will help bring servicing investment opportunities to a wider market, and at the same time help shore up the value of servicing assets.

This article serves as a primer for those looking to forge a subservicer-investor partnership. It will cover the key legal and business considerations that go into putting together such deals.

As a general rule, the overriding objective of most mortage bankers who service is to add servicing to their portfolio in the most profitable, cost-efficient way possible. The highest degree of profitability can be achieved when the servicing is low-risk (or better yet non-recourse) to the servicer in terms of potential foreclosure and REO losses, and when efficiencies can be achieved through the oft-cited economies of scale.

There are at least three ways that a mortage banker can "grow" a loan servicing portfolio. Multiple combinations of these three approaches can be fashioned to meet the specific needs and goals of any one company. For example, a mortgage banking company can increase the size of its loan servicing portfolio through loan production, origination and/or loan acquisition. Or, a company can acquire loan servicing, through a bidding process or direct negotiations, in the well-established and currently bountiful secondary market for servicing. Finally, a mortgage banker can increase the size of its servicing portfolio by sub-servicing loans and/or mortgage-backed securities on behalf of an investor who opts not to perform the daily servicing functions.

Such an investor is likely to view mortgage servicing as a real-estate-related asset that generates a relatively steady and predictable yield based on a cash stream. The cash stream is comprised of the servicing fee, income related to any escrows, and ancillary income such as late fees assumption fees, and so forth. As an offset against this cash stream, the investor assesses the expenses involved in such a deal including the sub-servicing fee, the likely "run-off" speed of the portfolio (i.e., prepays, payoffs and foreclosures) and the anticipated costs and expenses associated with foreclosures and REOs.

Three ways to grow servicing

Each of the three approaches to growing servicing assets has certain inherent costs and benefits that make them more or less attractive to a particular servicer. Increasing one's servicing portfolio through originating and/or buying loans with servicing rights is considerably more attractive to companies with a very large and cost-efficient origination and/or correspondent network. A small-to-medium size mortgage company probably would be unable to increase significantly its servicing portfolio through retail and/or wholesale production because the partial prepayments, full payoffs and foreclosures would greatly reduce any net gain of servicing which would be relatively small anyway. So, only consistently high-volume originators and purchasers of loans are likely to experience significant servicing growth through this means.

The second method of adding servicing - purchases in the secondary market - has its own inherent costs and benefits. Even in today's market-place where there is an abundant supply of servicing for sale at relatively low prices, a company must either have sufficient capital or be able to debt finance such purchases. Because of this, significant servicing growth by acquisition is best suited to large mortgage companies or companies owned or affiliated with capital-rich parents. A company with access to inexpensive funds to buy servicing is obviously at a distinct advantage over other potential buyers.

Furthermore, any leveraged acquisition is accompanied by a debt service obligation. The appearance of long-term debt on the borrower's balance sheet and other financial and accounting ramifications must be carefully weighed. This is particularly so in light of FIRREA, which dramatically tightens the capital and other accounting rules pertaining to commercial banks and thrifts. The law renders acquired loan servicing rights much less attractive as an investment for thrifts. This concern would apply whether or not the purchaser serviced or sub-contracted the servicing.

The subservicing alternative

The third way a mortgage banker can grow its loan servicing portfolio is by sub-servicing loans for one or more investors. From the sub-servicer's perspective, this means of enlarging the servicing operation is independent of loan production capacity and obviates the need for purchasing capital. Moreover, the sub-servicing alternative rules out potential risks tied to foreclosure and REO losses assuming those remain with the investor along with the majority of the servicing fee.

This alternative also enables the risks of prepayment speed to be reclassified from an "investment" risk to an "overhead" risk. There is absolutely no "basis" risk to the sub-servicer from prepayments. Finally, the sub-servicer is free of the potential accounting problems associated with acquired servicing. Essentially, mortgage bankers who subservice get a fee for performing servicing functions without being exposed to many of the risks shouldered by the investor who owns the servicing assets.

This subservicing approach is likely to appeal most to growth-oriented, efficient, low-overhead servicers because it should allow them to take further advantage of existing economies of scale and, thereby, lower their per-loan servicing costs. Regardless of how attractive this approach may appear at first blush, one must never lose sight of one glaring disadvantage. In the case of loan production and acquisition, the mortgage banker ultimately owns the servicing - an asset with readily identifiable market value. A sub-servicer never owns, nor can it sell, or pledge, sub-servicing rights. The sub-servicer is simply paid a fee to do a job - albeit one that presumably it can do very well and quite profitably. Furthermore, a contracted sub-servicer must always be aware of the risk that the servicing may be sold by the investor, seized by the guarantor or otherwise disposed of and pulled from the sub-servicer. These risks are best addressed in the sub-servicing agreement in a manner that will be discussed.

It should be noted that the author has chosen to focus on GNMA securities for illustrative purposes only and the servicing of other governmental or quasi-governmental agency securities would not appear to differ significantly.

Sub-servicing GNMAs

Overall, a sub-servicer performs all the traditional loan collection and administration functions on behalf of the investor (referred to also as the issuer/servicer) with respect to the loans. Such functions include collections, payment of taxes and insurance, customer service, handling telephone and written inquiries of borrowers, periodic escrow and loan analysis, and default-related activities such as bankruptcies, foreclosures and the disposition of REOs. Ginnie Mae permits these activities to be performed for the issuer/servicer by a sub-servicer. (The sub-contract servicer must be distinguished from service bureaus which, in general, perform only data processing and computer-related functions).

With respect to the servicing activities tied to GNMA securities, the GNMA guidelines are clear as to the permitted division of responsibility and activity between the issuer/servicer and the sub-servicer. There are two points that transcend the division of permitted activity about to be described. First, although the sub-servicer must be a GNMA-approved issuer/servicer and GNMA must approve the sub-servicer in each transaction, the GNMA capitalization requirements do not apply to the sub-servicer with regard to its sub-servicing obligations. The reason for this apparent laxity lead us directly to the second point. Regardless of the tasks performed by the sub-servicer, and despite GNMA approval of the issuer/servicer - sub-servicer relationship, ultimate financial liability vis-a-vis GNMA and the GNMA certificate holders lies exclusively with the issuer/servicer - the investor. It may be of little comfort to the issuer/servicer that it has legal recourse at a later date against its sub-servicer. That is one reason why the selection of a qualified sub-servicer is so critical to the investor.

The GNMA guidelines are quite clear as to those servicing functions that can be delegated to a sub-servicer. GNMA 5500.1 REV-5 provides that a sub-contract servicer, on behalf of the issuer/servicer, may: * collect principal, interest, taxes and

insurance from the mortgagors; * deposit such funds into the respective

custodial accounts; * withdraw funds from the escrow

accounts for the purpose of making

payments of taxes and hazard insurance

premiums on behalf of

mortgagors; * prepare checks to be delivered to

holders of the GNMA securities; * make advances on behalf of the

issuer/servicer of record for the

payment of principal and interest to

GNMA investors; * be responsible for foreclosure

losses; * prepare monthly reports to be submitted

to GNMA and; * submit GNMA monthly security balance


Conversely, that same GNMA provision precludes the issuer/servicer from delegating the following functions to another party: * withdrawal of dollars from the custodial

account containing principal

and interest; * removal of mortgage documents

from the custodian bank; * signing and mailing of checks to

GNMA certificate holders; * signing and submitting GNMA

monthly reports; * payment of the GNMA guaranty

fees, and; * maintenance of the register containing

pertinent GNMA certificate

holder information.

It is conceivable that GNMA officials may be willing to relax these regulations somewhat if approached on a case-by-case basis. GNMA's willingness to do so will, of course, depend upon the track record, experience and financial strength of the sub-servicer and the extent to which the issuer/servicer is or is not capable of performing the functions.

How an Investor should select a sub-servicer

(and vice-versa)

The most critical issue facing an investor in loan servicing who prefers to delegate servicing functions is the actual selection of a sub-servicer. Aside from certain geographic, economic and regulatory factors beyond control, the competence and capacity of the sub-servicer will most dramatically affect the cash flow and residual value of the investor's servicing portfolio Below is a list of essential criteria to be considered by an investor in loan servicing and a sub-servicer.

The sub-servicer should have significant experience in servicing or sub-servicing the particular type of loans and securities. Certain mortgage banking companies are more experienced in servicing certain types of loans, whether FHA, VA or conventional, and certain types of securities, whether GNMA, FNMA or FHLMC. An investor must ensure that the prospective sub-contract servicer is well suited to the loan servicing portfolio involved. In this regard, the investor should focus most on the collections, foreclosures and REO departments of the sub-servicer. The expertise and efficiency of a sub-servicer in performing these functions will determine the overall profitability of the servicing portfolio. Calculation of the investor's likely exposure must, to a great extent, begin with an analysis of the quality of the sub-servicer's default operations areas.

The prospective sub-servicer must be qualified and approved by the applicable government agency to service the loans and/or securities involved. As an adjunct, the sub-servicer should have a track record of superior loan servicing in the eyes of the government agency or agencies guaranteeing the loans and/or securities in the investor's portfolio.

The sub-servicer must have capacity to take on additional loan servicing. Capacity in this context refers to available office space and personnel, managers and supervisors capable of either managing additional people or getting more from existing staff, excess telephone and computer capability and a servicing system with built-in efficiencies capable of handling profitably the additional workload.

If a potential sub-servicer does not have this capacity in place, or in some stage of implementation, it is essential that the sub-servicer be capable of the necessary expansion without interrupting its ongoing daily operations. Obviously, a loan servicing system with excess capacity or one already being expanded to accommodate significant growth is preferable to a system running at maximum capacity.

The investor must have assurance that the sub-servicer will not "choke" on the additional volume, thereby risking the investor's servicing investment and the sub-servicer's ongoing operation. Ideally, an investor should look for a sub-servicer currently approaching maximum capacity, but with expansion plans and who has begun pursuing those expansion objectives independent of any particular investor or new portfolio. Such a sub-servicer, committed to growth, will likely create opportunities and should be seen as doing all it can to be well-positioned to take advantage of opportunities as they arise. The subservicer's prior commitment to growth should be of great importance to the investor. It provides a true indication of the sub-servicer's disposition toward growth and confidence about the future.

The investor must consider the financial arrangement with the sub-servicer, the primary component of which is probably the sub-servicing fee. The fee sought by the sub-servicer must be low enough to reflect an aggressive and efficient operation, but high enough to prove realistic and profitable to the sub-servicer. The investor must always remember that in many ways its financial fate is directly tied to that of the sub-servicer. Therefore the fee must be profitable to both parties. A sub-servicing fee not profitable to the sub-servicer jeopardizes the value of the entire servicing portfolio.

The investor's representatives should be actively involved in the details of the physical transfer of the loan servicing files and computer tapes to the sub-servicer. The mutual goals must be a smooth and orderly transfer in which the loans are integrated into the sub-servicer's system without interrupting current operations. An efficient transition most likely will signal that the loans were well-serviced prior to transfer, and the ability of the sub-servicer to continue properly servicing the loans. If the transition climate is one of panic, chaos and disorder, the investor must remedy the situation prior to completion of the transfer, after which the problem may well take on financially disatrous proportions.

In the context of an acquisition, it may be desirable from the investor's perspective to enlist the assistance and expertise of the sub-servicer in conducting the due diligence effort as to the status of the loans and their documentation. A mortgage banker sub-servicer may be of great value to an investor, particularly one unfamiliar with loan servicing, in reviewing servicing tapes and files and analyzing the quality of the servicing provided by the existing servicer. This may yield more peace of mind regarding the quality of the investment and the magnitude of the undertaking for both the investor and sub-servicer.

Possibly most significant is the basic compatibility of the investor and the sub-servicer. This criteria is amorphous and difficult to assess. It either exists or it doesn't. Both parties must be certain their long and short-term objectives are compatible. Management, philosophy and expertise must be complimentary to help blend the two parties into a unified and powerful entity - one very dependent on, and confident in, the other. In many ways, the harmony of this union will determine the ultimate success or failure of the arrangement.

The sub-servicing agreement: Which

Issues really matter?

While many provisions contained in a typical sub-servicing agreement are "boilerplate," several provisions must be specifically "tailored" to fit the parties. Certain sections of the agreement are absolutely essential to the financial success of one or the other party, or both. These sections may be heavily contested and hotly debated. Hence a brief discussion of those provisions is likely to raise serious debate, concern and even a few voices and eyebrows before the deal is completed.

Scope of agreement - This section is likely to be taken quite seriously and given a great deal of attention by both parties because it addresses precisely which loans are to be serviced by the sub-servicer and those if any, that are that are not. Arriving at the final results of this "sifting" process may not be as easy as one might think. Here is where a meeting of the minds must occur with respect to the composition, characteristics and pertinent cut-off dates for the portfolio being sub-serviced. For example, the parties must agree upon whether the portfolio will contain loans delinquent in excess of 60 days and, if so, as of what date.

Representations and warranties - This section generally contains the representations and warranties of both parties concerning (1) due incorporation, valid existence and good standing of the companies involved, (2) confirmation that needed corporate and government authorizations and approvals regarding purchase, ownership and/or transfer have been obtained, (3) good and marketable title to, and proper servicing of, the loans, (4) the status of the custodial accounts, loan balances, payment of taxes and insurance premiums and (5) the fact that there are no legal actions, pending or threatened, which would materially impair the ability of either party to perform its obligations under the agreement.

Although many of the representations and warranties just described appear to be relatively straightforward, the specific language used is often debated at length and carefully crafted so as to establish clear boundaries within which the representations apply.

Covenants - The only issues here that involve lengthy debates relate to the specific duties to be performed by the sub-servicer and those that the sub-servicer will not perform. Furthermore, this section may contain some controversial covenants concerning periodic reporting requirements, net worth maintenance, responsibility for and absorbtion of losses relating to foreclosures, REOs and prepayments, payment of advances of principal, interest, taxes and insurance and certain fees.

Sub-servicing fee - From the perspective of both parties, this section contains the most important feature of the financial arrangement - the amount and payment of the sub-servicing fee. The sub-servicing fee may be expressed either in terms of a flat dollar per loan fee or in terms of basis points multiplied by the outstanding principal balances on the loans, based on funds actually collected. The former expression is generally less risky to the sub-servicer because it will receive a sum certain with respect to each loan it sub-services, this amount is independent of collections and prepayment speed. It is my experience that most fees are calculated in accordance with the second method. This section also generally contains arrangements regarding incentive compensation, if any, the ownership of, and fee income related to escrow funds and ancillary income derived from late charges, assumption fees and so forth.

Indemnification - The indemnification and "hold harmless" provisions of the agreement are always analyzed very carefully by attorneys for both sides. It is in this section of the agreement that the legal standards of care of the parties are set forth and the responsibilities for improper servicing and factual misrepresentations are spelled out. These provisions are generally very carefully worded and crafted to suit the parties and the level of performance expected.

Term and termination - Often, this section is the most controversial and hotly contested. Generally, the provisions relating to term and termination for cause are quite standard. Most sub-servicing agreements have a term equal to the life of the underlying mortgage loans and may be terminated by the investor for cause. Cause is typically defined as a breach of, or default under, the agreement (i.e., a breach of a representation, warranty or covenant, a factual misrepresentation or inferior servicing performance). However, termination of the sub-contract servicer without cause is a provision that most sub-servicers prefer not seeing or that they will want to see carry a stiff penalty to be paid to the sub-servicer. Obviously, good sub-servicers are reluctant to enter into arrangements that may be terminated at any time without cause.

As to the size of the termination penalty, the sub-servicer will try to negotiate the highest fee possible. Some agreements contain a sliding scale with higher cancellation penalties in the early years of an agreement that decrease toward the end of the agreement. While there is no standard market penalty, no-cause termination fees in this context generally range from 25 to 100 basis points multiplied by the then outstanding principal balances on the loans at the time of termination.

Does sub-servicing have a future?

There will always be those investors who prefer, for economic reasons, to sub-contract the servicing functions and view servicing purely as an investment. Especially in today's market where servicing is plentiful and good values abound, a broker or seller can significantly expand the pool of potential buyers by approaching "pure" investors with a servicing package and a qualified sub-servicer.

From the mortgage banker's perspective, sub-servicing should become a popular method of "growing" a company's servicing portfolio.

Growth and consolidation in the mortgage banking industry is certain to continue.

Joel R. Katz is vice president and counsel of National Mortgage Company, Memphis.
COPYRIGHT 1990 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage banks, includes related article
Author:Katz, Joel R.
Publication:Mortgage Banking
Date:Feb 1, 1990
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