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Magnifying servicing's fine print: paying attention to detail can reveal hidden traps in servicing contracts.

Magnifying Servicing's Fine Print

Paying attention to detail can reveal hidden traps in servicing contracts.

Reports of the escalated volume of servicing transfers are not exaggerated. Servicing is being transferred involuntarily and voluntarily between non-related parties and related parties. The underlying reason for these transactions is no longer just a simple need to convert assets to cash. Consequently, the principle "caveat emptor" is now frequently tested. The sheer volume of transactions, recourse risk, and transfer risk, and the stringent regulation of servicing transfers have all given rise to "caveat mortgagee"--and a heightened concern for due diligence.

Due diligence is both an offensive and defensive activity that can be managed equally within a lender's quality control or audit departments. If a lender truly subscribes to the principle that servicing is a managed asset, then the lender will be both a buyer and a seller. Active due diligence, known in-house as quality control, will test the value of current servicing, uncover growing risk and operational problems to "defend" against loss of market value. It will also flag potential claims for servicing errors, omissions and involuntary transfers. An efficient due diligence process should uncover unwanted risk and actual costs that reduce asset value. During an acquisition deal, due diligence is a familiar activity that supports an offensive or growth strategy and confirms that the company is getting what it paid for.

The mortgage lender, whether acting as buyer or seller, should address due diligence as both a quality control function and an audit function. The issues are significant because a thorough review of the servicing's value--going beyond the usual review of documentation and custodial account balances--might reveal that the asset is actually worth less than the market value.

The following are some basic representation and warranty paragraphs usually found in buy/sell agreements that can make or break asset value, even when the transaction is as patently simple as that between parent and subsidiary.

Confirm the first representation or warranty: "duly organized, good standing, authorized to do business." Obtain current copies of good standing certificates and required licenses or exemptions. A common problem can crop up when servicing is transferred between an insured financial parent, which may be exempt from laws and regulations requiring state licenses or authorities to do business in a state, and a subsidiary which may not be exempt. If this is the case, the subsidiary may be able to obtain a specific exemption or post bond. Review the state locations of servicing for authority and license requirements, not just tax and interest on escrows. Other state "good standing" issues will include abandoned property filings, income tax, franchise taxes, and so forth.

After confirming the "authorizations" for the servicing side, identify the originator and funding firm from the loan files. Were the loans originated and funded by authorized and licensed brokers or lenders? Remember that the buyer of servicing can often end up assuming all or some origination liabilities.

Loan servicing acquired from previous acquisition transactions can also be a complicating factor. Note all prior servicers and review a copy of any previous sale or transfer agreement to confirm precisely which rights and obligations will be transferred. Buying servicing at a price of 200 basis points (bps) with a not-for-cause termination fee of 100 bps significantly changes the asset value.

The second representation and warranty: authority to execute the transaction. Obtain a copy of the director and officer nomination resolutions and the resolution authorizing the purchase and sale. Transactions between parent and corporate subsidiary often overlook this element because they are "family." Further, insured financial parents often have loan servicing performed in a servicing subsidiary for a nominal or normal fee without a servicing contract. Sale of the parent's loan servicing portfolio, absent this contract, would violate the authority to execute because the subsidiary may be selling an asset it doesn't own.

The third representation and warranty: consents. Beyond the investor consents are those involving mortgage insurers, voluntary insurance carriers and other third parties. Many of these relationships require notice and approval of the transfer prior to the mechanical change in mortgagee. Obtain a complete list of all third party contracts and review the contract status and consent issues.

Check and obtain a warranty and indemnification that there are no "buy back" or "pay-up" (loss recovery) letters between the seller and any third party. A cross reference list of insurers and master policy numbers and a servicing transfer cross reference check sheet are useful internal auditing tools.

Voluntary insurance contracts can hand a servicer by the thumbs. Many insurance companies' contracts state that the policy will terminate upon transfer. A claim payment under a "terminated" contract (assuming the mortgagor has paid current under its terms) could be a costly lapse of attention to detail.

Review the loan sale and servicing agreement for private investors in particular. Many private investors use agreements that are custom made or variations of standard agreements. But beware--the "standard" may look vanilla but taste like cardboard. Lenders should look for any servicing issues related to the site of custodial accounts (FDIC vs. FSLIC), consents, special insurance (such as earthquake), remittance dates and reports, recovery of advances and recourse.

Review repurchase requirements and the termination clause. A not-for-cause termination clause that requires an appraiser valuation to be paid for by the servicer can make a big difference in a small portfolio that a private investor might want to take back. It wouldn't be a bad idea to see if a copy of the annual certification (stating that the investor portfolio has been properly serviced) is on file in the investor correspondence file. A sleeper in many transactions involves participation servicing where the seller, often an insured institution, is the investor and servicer for its portion. Pricing issues for the servicing covering the retained participation portion should be reflected in the service fee agreement.

Review the representation and warranty that states: "all loans that are first (or second) liens (not contracts for deed) on a specific collateral with marketable title and seller can assign same." This is a tedious but crucial loan documentation review, and the assignment problems in particular, including intervening assignments, can chew up a significant amount of time and money. If the servicing is being acquired from a thrift that has acquired others or is itself a merged institution, obtain copies of the merger orders to shorten intervening assignments.

Review the usual and customary balancing and open item issues: P&I custodial accounts, escrow accounts, buydown, suspense and fee accounts. If an ad hoc system of reporting exists, logic tests can be run to review certain conditions: maturity dates, LTV's greater than 80 percent without escrow balances, service fees outside of expected ranges, MIP/PMI and VA certificate numbers equal to zero or outside of expected ranges. The tax department does not like to see tax contract or parcel numbers equal to zero and legal descriptions that say "see attached." A lender's nightmare is to buy or sell an ARM loan that has not been properly set up for notification, index value or change, rounding up/down or moving through floors and ceilings. If a lender notices many escrow advances, bells should go off for collections, escrow analysis and delinquent taxes. In addition, don't forget to obtain written forebearance agreements and check for stale delinquent accounts, bankruptcies and foreclosures.

Last, correspondence should be reviewed. Audits, repurchase demands, investor, customer and custodial correspondence may seem less than exciting but often reflect the true quality of servicing and risks not factored into the pricing model. Denied mortgage insurance claim letters and correspondence noting high volumes of force placed coverage can reveal much about a particular loan package.

"Caveat mortgagee" requires that the seller know as much as possible about the portfolio and keep in mind that servicing is an asset that should always be properly maintained and ready for sale. The buyer must be aware that the attractive portfolio strategy and pro forma pricing from the pricing model can unravel if it is not supported by solid facts and good documentation. The industry must be aware that this is a customer business that entails fiduciary responsibilities to investors, mortgagors, insurers and guarantors, regulators and even its own origination department, auditors and brokers.

The acid test: You have just been given a check in the amount of the internal value of your servicing portfolio. What would you pay on a competitive bid basis for your portfolio after your due diligence examination? Would you buy it, and if so, under what conditions? Would you feel comfortable signing the same seller representation and warranties you would require as a buyer?

Caveat mortgagee.

Frederick J. Horak is the vice president of asset acquisition and sales for First Gibralter Bank, F.S.B. in Houston. He is responsible for the bank's servicing acquisition due diligence, contracts and operational issues.
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Author:Horak, Frederick J.
Publication:Mortgage Banking
Date:Jun 1, 1990
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